Fund Structuring & Operations

Transcription

1 MUMBAI SILICON VALLEY BANGALORE SINGAPORE MUMBAI BKC NEW DELHI MUNICH NEW YORK Fund Structuring & Operations Global, Regulatory and Tax developments impacting India focused funds June 2017 Copyright 2017 Nishith Desai Associates

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3 Fund Structuring & Operations Global, Regulatory and Tax developments impacting India focused funds June 2017 MUMBAI SILICON VALLEY BANGALORE SINGAPORE MUMBAI BKC NEW DELHI MUNICH NEW YORK

4 Provided upon request only Dear Friend, According to recent global LP surveys, India is being seen as the most attractive emerging market for allocating fresh commitments. While 2015 and 2016 saw an year-on-year decline in India-focused fund-raising, this may have been due to renewed focus by GPs on deal-making given the dry-powder overhang. However, as GPs hit the road in 2017 for new fund-raises, the year promises to be an interesting vintage for India-focused funds. The investor appetite for India risk has been robust and that led to healthy fund raising for several tier 1 GPs with track records. The fund raising environment in 2016 (and continuing) has seen spurred efforts in India with the regulatory reforms in foreign exchange laws with respect to onshore funds introduced in the last quarter of 2015 and tax certainty brought about by the protocols signed by India to its double taxation avoidance agreements with various jurisdictions included Mauritius and Singapore. The regulatory changes are aimed at promoting home-grown investment managers by allowing Indian managed and sponsored AIFs with foreign investors to bypass the FDI Policy for making investments in Indian companies. The government has been proactive in trying to establish a regulatory and tax climate that is conducive for raising investment from foreign investors. In 2016, the government also made efforts to encourage domestic financial institutions such as pension funds and insurance firms to allocate investments towards alternative asset classes such as Indian AIFs. The regulatory regime continues to be streamlined with relaxation of pricing norms for foreign direct investments, clarity in relation to put / call options, rationalization of the foreign portfolio investment regime and proposals for further liberalization of investment caps. Designing a fund is not just an exercise in structuring. It s like being an architect is different from being a structural engineer. For India-focused funds, not only knowledge of Indian regulatory and tax framework is required but a deep insight into cross border legal and tax regimes is necessary, even when you are not raising funds from overseas. The investment fund industry clearly seems to be in a very different market today. In mid-2016, Indian funds started seeing greater participation from domestic LPs (as compared to so far being primarily led by overseas investors). Innovative structures varied from the traditional blind-pool model are increasingly being seen. One of the major themes that continues in 2017 is the shift from co-investment structures to unified structures, specially in funds with both domestic and foreign LP participation given the relaxation of FDI norms for investment in AIFs and tax certainty brought about by recent changes to the double taxation avoidance agreements of India with different countries. India, as an investment destination, has also gained popularity among hedge funds. Innovative structures such as hedge funds with private equity side pockets are also being adopted. Following closely on the footsteps of the observations by U.S. Securities and Exchange Commission ( SEC ) that there are several disconnects between what [general partners] think their [limited partners] know and what LPs actually know, SEBI mandates certain disclosure and reporting norms that AIFs have to observe. However, from a regulatory viewpoint, the glare from the regulator to the alternative investments space has been at its peak. A manager to an alternative investment fund ( AIF ) must now contend with greater supervision and accountability to both the regulator and the investors. While bespoke terms are designed to maintain investor friendliness, given the recent observations by regulators in sophisticated jurisdictions, sight must not be lost on the disclosure norms and fiduciary driven rules that are now statutorily mandated.

5 Fund Structuring & Operations Global, Regulatory and Tax developments impacting India focused funds There is some market hesitation about the changes introduced by the protocol signed between India and Mauritius to amend the Mauritius India Double Taxation Avoidance Agreement (the Protocol ) as it gives India a source based right to taxation of capital gains arising out of sale of shares. The Protocol should be seen as a welcome change as it brings certainty coupled with easing of tax rates in India and added benefits in respect of interest income. Mauritius will now emerge as the preferred jurisdiction for debt considering the lower withholding tax rates for interest income. Further, investments through Mauritius will be less likely to be questioned under the General Anti-Avoidance Rules which allows Indian tax authorities to re-characterize transactions on grounds of lack of commercial substance among other things, and has come into effect from April 01, In the United States, the primary laws regulating investment funds are the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940 and the Investment Advisers Act of Following the financial crisis of 2008, a number of legislations have been introduced. These include the Dodd- Frank Act, the Foreign Account Tax Compliance Act ( FATCA ) and the Jumpstart Our Business Startups Act ( JOBS Act ). These legislations were enacted with the twin purpose of preventing future financial crisis on one hand and facilitating the process of economic recovery on the other. From an investment fund perspective, these statutes assume importance in the context of investor limitations and disclosure requirements that they usher into the regulatory regime. The European Commission introduced the Alternative Investment Fund Managers Directive ( AIFMD ) with a view to provide a harmonized and stringent regulatory and supervisory framework for the activities of fund managers within the European Union. The AIFMD seeks to regulate non-eu fund managers who seek to market a fund, set up outside the EU to investors in the EU. Back home, in 2015, SEBI had constituted a standing committee called the Alternative Investment Policy Advisory Committee ( AIPAC ) under the chairmanship of Mr. Narayana Murthy to advise SEBI on measures to further develop the alternative investment and startup ecosystem in India and to highlight any hurdles that might hinder the industry s development. The first AIPAC report of January, 2016 recommends various structural reforms and seeks to push regulation of funds to next practices. Some of the recommendations were adopted in the 2016 annual budget that was tabled by the Finance Minister. The second AIPAC report of December, 2016 recommends changes which pertain to more detailed disclosures in the offering documents by the GPs, better reporting norms, unlocking the domestic pool of capital (pension funds and insurance companies), performance statistics and benchmarks to be standardized for the industry. The AIPAC reports mark a welcome start for necessary dialogue that is required between the industry and the regulator; however, the recommendations have not yet been translated into changes. Moreover, there is also emerging jurisprudence which suggests that the threshold of fiduciary duties to be met with by fund managers is shifting from exercising supervision to making reasonable and proportionate efforts commensurate with the situations. A failure to perform such supervisory role could raise severe issues on fund managers liabilities for business losses as would be seen in the case of fund directors in Weavering Macro Fixed Income Fund, which continues hold the most value in terms of precedence in fund governance jurisprudence (summarized in our memo that can be accessed at Governance.pdf). To add to this, there has been a very active enforcement of anti-corruption laws under the Foreign Corrupt Practices Act ( FCPA ) against directors and executives. Accordingly, apart from the expectation to set up investor-friendly structures, the shift in legal paradigm in which an investment fund operates, requires that attention be given to articulating disclosures in fund documents (including recording the economic substance and justifications in the fund s board minutes) and intelligently planning investment asset-holdings.

6 Provided upon request only Globally, funds have been accorded pass through status to ensure fiscal neutrality and investors are taxed based on their status. This is especially relevant when certain streams of income may be tax free at investor level due to the status of the investor, but taxable at fund level. India has also accorded a pass through status to Category I and Category II AIFs registered with SEBI with a requirement to subject any income credited or paid by the AIFs to a withholding tax of 10% for resident investors and as per the rates in force for non-resident investors. Pass through status has still not been accorded to Category III AIFs. The tax uncertainty places category III AIFs at a significant disadvantage against offshore funds with similar strategies. While bespoke managed accounts are being created and structures that meet LPs demand to be more closely aligned to the portfolio selection process are being set up, it is imperative to design funds which address the issues created by the continuously changing Indian and international regulatory and tax environment. The shift in legal paradigm in which an investment fund operates requires that attention be given to articulating disclosures in fund documents (including recording the economic substance) and intelligently planning investment asset-holdings. In our experience, fund documentation is critical in ensuring protection for fund managers (GPs) from exposure to legal, tax and regulatory risks. Fund counsels are now required to devise innovative structures and advise investors on terms for meeting investor s (LP) expectations on commercials, governance and maintaining GP discipline on the articulated investment strategy of the fund. All these are to be done in conformity with the changing legal framework. The objective of this compilation is to bring to focus, aspects that need to be considered while setting up Indiafocused funds and some of the recent developments that impact the fund management industry. Regards, Nishith Desai

7 NDA Fund Formation Practice Fund Structuring & Operations Global, Regulatory and Tax developments impacting India focused funds Our Approach At Nishith Desai Associates, we are particularly known and engaged by multinational companies and funds as strategic counsels. As engineers of some of the earliest innovative instruments being used by investment funds (both private equity and venture capital) in India we proactively spend time in developing an advanced understanding of the industry as well as the current legal, regulatory and tax regime. Choice of Fund Vehicle Structure follows strategy, and not vice versa. Developing an appropriate strategy is crucial in determining not just the structure, but also the architecture of the fund platform. Selection of the fund vehicle requires careful planning and is driven by a variety of considerations as the same would have an impact on the investors in the fund; particularly in their home jurisdictions. While deciding on the optimum structure for a fund, varied objectives such as limited liability for investors, commercial convenience and tax efficiency for investors and managers need to be considered. To meet these objectives, varied entities such as pass-through trusts, limited liability partnerships, limited partnerships, limited liability companies, protected cell companies etc. can be considered. Offshore funds investing in India may require the presence of investment advisors in India to provide them with deal recommendations etc. This gives rise to tricky issues relating to the taxation of such offshore funds in India that would depend on whether the Indian advisor is regarded as a permanent establishment of the offshore fund in India or may lead to a risk of place of effective management of the offshore fund held to be in India. In this regard, we have successfully represented several funds before the Indian Authority for Advance Rulings and have obtained landmark rulings for them. After the Organisation for Economic Co-operation and Development ( OECD ) issued its report on Action Plan on Base Erosion and Profit Shifting ( BEPS ), there has been an increased pressure to ensure observance of key tax principles like demonstrating substance, establishing tax resident status and transfer pricing principles. Tax authorities in several mature financial centers are adopting substance over form approach. The implementation of the General Anti-Avoidance Rules allows Indian tax authorities to re-characterize transactions on grounds of lack of commercial substance among other things. This has prompted a shift while structuring funds to concentrate several aspects constituting commercial substance in the same entity. So, unless specific investors require feeder vehicles for tax or regulatory reasons, an attempt is being made to pool LPs in the same vehicle that invests in the foreign portfolio. Mauritius, Netherlands, Singapore and Luxembourg continue being favorably considered while structuring India funds or funds with India allocation. To accommodate both domestic investor base and offshore investor base, unified structures have emerged as a preferred choice for structuring India focused funds. There is also an increased participation from development financial institutions ( DFIs ) in India focused funds, including unified structures. Accordingly, some global benchmarks need to be followed when designing the structure and calibrating the fund documents including the governance, fiduciary aspects and adherence to Environment and Social ( ESG ) policies.

8 Provided upon request only Documentation Once a decision has been taken on the optimum structure for the fund, the same has to be carefully incorporated in the fund documents including the charter documents for the fund entity, the private placement memorandum, the shareholders agreement, the share subscription or contribution agreement, the investment management agreement, the investment advisory agreement, etc. In particular, one would need to keep in mind the potential permanent establishment risk while drafting these documents. The private placement memorandum should also achieve a balance between the risk disclosure requirements and the marketing strategy. We also co-ordinate with overseas counsel to obtain requisite legends to keep the fundraising exercise compliant with the laws of each jurisdiction in which the interests of the fund are being marketed. Advisory In addition to preparing the necessary fund documents, we also advise the fund on the local registration requirements. Domestic funds may register themselves with SEBI pursuant to which they are required to comply with certain investment restrictions and other prescribed conditions. Domestic funds are also accorded pass- through status for Indian tax purposes upon the fulfillment of certain conditions. It is not mandatory for offshore funds to register with SEBI. However, there are certain benefits available to offshore funds that register with SEBI as foreign venture capital investors such as flexibility in entry and exit pricing, Qualified Institutional Buyer status, etc. Further, with respect to funds seeking to participate in the secondary markets, apart from drafting of the information memorandum which is circulated to the investors of such fund, we have also advised and assisted them in obtaining registration as foreign portfolio investors. We also advise funds on a day to day basis from an Indian tax and regulatory perspective in relation to the execution of offshore derivative instruments including participatory notes. LP Negotiations LPs (particularly the first close LPs and institutional investors) to India focused funds have increasingly started negotiating fund terms with the GPs with rigorous review of the fund documentation. Further, there is often a need to harmonize the fund documents to cater to the requirements of foreign institutional investors / DFIs, which may vary or differ from those of Indian financial institutions. Funds with a mixed pool of investors (domestic and foreign, institutional and retail) often face various issues on fund terms including with respect to allocation of placement agent expenses, set-up costs for a feeder vehicle to cater to foreign investors, exposure of the corpus of the fund to exchange rate fluctuations. Therefore, it not only becomes critical for GPs to ensure that they are able to accommodate the LP asks within the realms of the structure in the most efficient manner but also for the legal advisors to ensure that they are adequately incorporated in the fund documentation.

9 Fund Structuring & Operations Global, Regulatory and Tax developments impacting India focused funds Project Management Several Indian investment managers who are looking at raising international funds need to offer tax efficient and regulatory compliant structures to their foreign investors that generally seek not only safety and repatriation of their original investments, but also a tax-efficient way of receiving the gains earned as well. Thus, our focus on international tax and our in-depth understanding of the legal, regulatory and tax regimes for funds in different jurisdictions has enabled us to be at the cutting edge of structuring offshore and domestic funds.

10 Provided upon request only Primary Contacts Nishith Desai Nishith Desai is the founder of the research-based strategy driven international law firm, Nishith Desai Associates ( with offices in Mumbai, Silicon Valley, Bangalore, Singapore, Mumbai BKC, New Delhi, Munich and New York. Nishith himself is a renowned international tax, corporate, IP lawyer researcher, published author and lecturer in leading academic institutions around the world. He specializes in Financial Services sector and assisted Government of Mauritius and Government of India in establishment of their offshore financial centers. Soon after India opened up its economy to the outside world in 1991, he established the first five India Focused funds and pioneered the roots of asset management industry and the firm has now worked for over 900 funds across all classes of asset. As a pioneer in the Indian investment funds industry, Nishith is known for developing new models in fund formation such as the first India focused index fund, first private equity fund, first VC fund and real estate fund and was also a member of SEBI s committee which developed original regulations for Foreign Venture Capital Investor (FVCI) and Venture Capital Funds regime. More recently, he has been involved with the formation and subsequent amendments to the AIF Regulations. Richie Sancheti richie.sancheti@nishithdesai.com Richie leads the Funds Practice Group at Nishith Desai Associates and is based in Mumbai. With a strong funds background, he advises on optimum structures for setting up onshore and offshore investment funds. He advises fund managers in connection with the formation, carry allocation program and governance of private funds. Richie specializes in all aspects of the formation and operation of venture capital, private equity and hedge funds that are focused on investing in India. He has extensive experience in designing fund structures and advising on market terms. Richie is also a member of the firm s international tax and private equity investment practice groups and advises clients on matters including private equity transactions. Pratibha Jain pratibha.jain@nishithdesai.com Pratibha Jain is the Founding Partner and also the Head of the Delhi office of Nishith Desai Associates. She heads the Banking and Finance and Regulatory practice at NDA. Ms. Jain brings with her a breadth of international and Indian experience having worked in New York, Tokyo, Hong Kong and Mumbai. Ms. Jain s educational qualifications include B.A (Economics) Hons. and LL.B. degree from Delhi University, a Bachelor of Civil Law degree from the University of Oxford, and a LL.M. degree from the Harvard Law School. Her areas of focus include FDI investments, banking and finance and corporate and regulatory advisory. Her client list includes marquee corporate and private equity clients including, Softbank, Amazon, Flipkart, Morgan Stanley, JP Morgan Chase, Deutsche Bank, Deutsche Boerse, Tiger Global, Soros, Norwest Venture Partners, Gen-

11 Fund Structuring & Operations Global, Regulatory and Tax developments impacting India focused funds eral Atlantic, SAIF Partners, Everstone Capital, Bombay Stock Exchange and Ministry of Finance. She sits on various important committees including FICCI Capital Markets Committee and FICCI Sub-committee on Internet and Social Media. She has worked on some of the most challenging projects in financial services and regulatory sector, including representing Ministry of Finance for structuring of India s first sovereign wealth fund with proposed corpus of over six billion dollars and advising Ministry of Commerce on their policy on Bilateral Investment Treaties, representing FDI investors in multiple acquisitions and entry strategies into India, representing investors for facilitating listing of stock exchanges in India, representing underwriter s for listing of Bombay Stock Exchange, representing investors in investigations by the Enforcement Directorate and representing FSSAI on creating regulations for audits. Nishchal Joshipura nishchal.joshipura@nishithdesai.com Nishchal Joshipura is a Partner and co-heads the Fund Formation practice at Nishith Desai Associates. He is a Chartered Accountant, an MBA and a Lawyer. He is also a Partner in the Mergers & Acquisition and Private Equity practice. Nishchal specializes in legal and tax structuring of cross-border transactions and assists clients on documentation and negotiation of mergers and acquisition (M&A) deals. His other practice areas include Corporate & Securities laws, Transfer Pricing, International Taxation, Globalization, Structuring of Inbound / Outbound Investments, Private Equity Investments, Structuring of Offshore Funds, Taxation of E-Commerce and Exchange Controls. He has contributed several articles in leading publications like Asialaw and has been a speaker at many domestic and international conferences. He has been highly Highly Recommended by various legal directories for legal and tax advice on M&A, Private Equity and Investment Funds. He has been nominated as a Young Achiever at the Legal Era Awards 2015 based on industry research, reviews, rating and surveys conducted by Legal Era. Mansi Seth mansi.seth@nishithdesai.com Mansi Seth leads Nishith Desai Associates US practice and is based out of New York. With expertise in investment funds and international tax, Mansi advises on structuring India-focused offshore and domestic private equity, venture capital and hedge funds. She has assisted fund managers with formation, regulation and carried interest structuring issues. On the tax front, Mansi focuses on cross-border tax planning structures, including mergers, acquisitions, joint ventures, private equity and venture capital investments and globalization. Mansi is qualified to practice law in India and New York and has received her Master of Laws degree in Taxation from Georgetown University in Washington DC. She has presented in a number of international and Indian conferences. She has also authored many articles and has been the recipient of the Tax Section scholarship of the International Bar Association.

12 Provided upon request only Kishore Joshi Kishore Joshi heads the Regulatory Practice at Nishith Desai Associates. He has over two decades of experience in advising clients on securities and exchange control laws. He handles matters on various aspects related to foreign portfolio investors including the broad-based criteria, eligibility to trade P-Notes and the participation of various investor categories under the FPI route. Kishore has interacted extensively with the securities and exchange control regulator and has made numerous representations seeking reform in the law. In addition, he regularly advises clients on fund investments, issues related to corporate and regulatory laws. He has made several presentations on inbound and outbound investments. Kishore holds a Bachelor s degree in law from Mumbai University and is a member of the Bar Council of Maharashtra & Goa.

13 Fund Structuring & Operations Global, Regulatory and Tax developments impacting India focused funds Contents 1. GLOSSARY OF TERMS CHOICE OF JURISDICTION FOR SETTING UP AN INDIA-FOCUSED FUND 04 I. Why Offshore Investors are Pooled Outside India 04 II. Why Onshore Investors are Pooled in India 04 III. Which Jurisdictions are Typically Considered for Setting up India-Focused Funds Pooling Offshore Investors 05 IV. Recent Changes STRUCTURAL ALTERNATIVES FOR INDIA-FOCUSED FUNDS 09 I. Foreign Investment Regimes 09 II. Certain Tax Risks ALTERNATIVE INVESTMENT FUNDS IN INDIA 15 I. Introduction 15 II. Alternative Investment Funds 15 III. Choice of Pooling Vehicle 16 IV. Classification of AIFs 18 V. Investment Conditions and Restrictions under the AIF Regulations 18 VI. Key Themes under the AIF Regulations 19 VII. Taxation of Alternative Investment Funds TRENDS IN PRIVATE EQUITY 25 I. Favorable reasons for a unified structure 25 II. Trending fund terms FUND DOCUMENTATION 30 I. At the Offshore Fund level 30 II. At the Onshore Fund level 31 III. Investor Side Letters 32 IV. Agreements with Service Providers HEDGE FUNDS 33 I. FPI Regulations 33 II. Participatory Notes and Derivative Instruments 39 III. Onshore Hedge Funds FUND GOVERNANCE 44 I. Investment Manager 44 II. Investment Committee 44 III. Advisory Board 44 IV. Aspects and Fiduciaries to be considered by Fund Directors 44

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15 Fund Structuring & Operations Global, Regulatory and Tax developments impacting India focused funds 9. INTERNATIONAL TAX CONSIDERATIONS 48 I. Taxation of Indirect Transfers 48 II. General Anti-Avoidance Rule (GAAR) 50 III. Business Connection / Permanent Establish- ment Exposure 52 ANNEXURE I 55 Sector Focused Funds 55 ANNEXURE II 59 Summary of Tax Treatment for Mauritius and Singapore Based Entities Participating in Indian Opportunities 59

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17 Fund Structuring & Operations Legal & Tax Issues 1. Glossary of Terms Sr No. Term Explanation 1. AAR Authority for Advance Ruling, Ministry of Finance, Government of India. 2. AIF Alternative Investment Fund as defined under the SEBI (Alternative Investment Funds) Regulations, AIF Regulations SEBI (Alternative Investment Funds) Regulations, AOP Association of Persons 5. CBDT Central Bureau of Direct Taxes, Department of Revenue, Ministry of Finance, Government of India 6. CCD Compulsorily Convertible Debentures 7. CCPS Compulsorily Convertible Preference Share 8. COR Certificate of Registration 9. DDP Designated Depository Participant 10. DDT Dividend Distribution Tax 11. DTAA Double Taxation Avoidance Agreement 12. ECB External Commercial Borrowing 13. FATF Financial Action Task Force 14. FCCB Foreign Currency Convertible Bond 15. FDI/FDI Policy Foreign Direct Investment / Consolidated Foreign Direct Investment Circular of FEMA Foreign Exchange Management Act, FII Foreign Institutional Investor 18. FIPB Foreign Investment Promotion Board, Department of Economic Affairs, Ministry of Finance, Government of India 19. FII Regulations SEBI (Foreign Institutional Investors) Regulations, FPI Foreign Portfolio Investor 21. FPI Regulations SEBI (Foreign Portfolio Investors) Regulations, FSC Financial Services Commission, Mauritius 23. FVCI Foreign Venture Capital Investor 24. FVCI Regulations SEBI (Foreign Venture Capital Investors) Regulations, GAAR General Anti Avoidance Rules 26. GBC 1 Category 1 Global Business (GBC 1) License 1

18 Provided upon request only 27. FTS Fees for Technical Services 28. GPs General Partners (Fund Managers) 29. GoI Government of India 30. IC Investment Committee 31. ICDR Regulations 32. Indian Rupee or INR or Rs. SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 The currency of Republic of India. 33. InvIT Infrastructure Investment Trust registered with SEBI under the SEBI (Infrastructure Investment Trusts) Regulations, IP Intellectual Property 35. IPO Initial Public Offer 36. KYC Know Your Customer 37. LoB Limitations on DTAA Benefits 38. LLP Limited Liability Partnership 39. LLP Act Limited Liability Partnership Act, LPAC Limited Partners Advisory Committee 41. LPs Limited Partners (Fund Investors) 42. MAT Minimum Alternate Tax 43. NAV Net Asset Value 44. NCD Non-convertible Debentures 45. NRI Non Resident Indian 46. OCB Overseas Corporate Body 47. ODI Offshore Derivative Instrument 48. OEIC Open-ended Investment Company 49. Offshore Fund Means a pooling vehicle established outside India. 50. PCC Protected Cell Companies 51. PE Private Equity 52. PPM Private Placement Memorandum 53. P-Notes Participatory Notes 54. POEM Place of Effective Management 55. Protocol Protocol signed between India and Mauritius to amend the Mauritius India Double Taxation Avoidance Agreement 56. REITs Real Estate Investment Trusts 57. RE Funds Real Estate Funds 58. QFI Qualified Foreign Investor 2

19 Fund Structuring & Operations Legal & Tax Issues 59 RBI Reserve Bank of India 60. SEBI Securities and Exchange Board of India 61. SGD Singapore Dollars 62. SITA Singapore Income Tax Act 63. SMEs Small and Medium-sized Enterprises 64. SPCs Segregated Portfolio Companies 65. SPV Special Purpose Vehicle 66. Tax Act or ITA Income Tax Act, TDS Tax Deducted at Source 68. TRC Tax Residency Certificate 69. TISPRO Foreign Exchange Management (Transfer and Issue of Security by a Person Resident Outside India) Regulations, USD US Dollars 71. VCF Venture Capital Fund 72. VCF Regulations SEBI (Venture Capital Funds) Regulations, VCPE Venture Capital and Private Equity 74. VCU Venture Capital Undertaking 3

20 Provided upon request only 2. Choice of Jurisdiction for Setting up an India-Focused Fund There are several factors that inform the choice of jurisdiction for setting up a pooled investment vehicle. A suitable jurisdiction for setting up a fund should primarily allow tax neutrality to the investors. Neutrality ensures investors are not subject to any higher taxes than if they were to invest directly. From a regulatory viewpoint, the jurisdiction should allow flexibility in raising commitments from resident as well as non-resident investors, making investments and distribution of profits. The government is working towards easing norms for effective mobilization of the domestic pool of investors in India (consisting of institutional investors like banks, insurance companies, mutual funds and high net worth individuals). The recent AIPAC Report 1 has also recommended unlocking domestic capital pools for providing fund managers an access to domestic pools as this investor class currently constitutes approximately 10% of the total VCPE invested in India annually. I. Why Offshore Investors are Pooled Outside India India follows source based taxation on capital gains and taxes thereon may not be creditable in the home jurisdiction of the offshore investors. Accordingly, offshore structures are used for offshore investors to invest into India to avoid double taxation on the same income stream. Further, if the offshore investors are pooled outside India, the requirement to obtain a Permanent Account Number ( PAN ) card and filing of tax returns will 1. The report was issued on December 01, 2016 and can be accessed at Our memo on AIPAC I (dated January 20, 2016) can also be accessed at information/research-and-arti- cles/nda-hotline/nda-hotline-single-view/newsid/3304/html/1. html?no_cache=1). only be on the offshore fund, as opposed to each of the offshore investors (in case of direct participation of such investors in an onshore pooling vehicle). Further, India does not have Bilateral Investment Promotion and Protection Agreements ( BIPA ) with all countries. Offshore investors are accordingly pooled in jurisdictions which have a BIPA with India,, which may provide investors an access to several reliefs, including fair and equitable treatment, protection against expropriation, repatriability of capital, an efficient dispute resolution framework and other rights and reliefs. Further, India based structures with foreign participation which are not Indian managed and sponsored may require regulatory approvals, compliance with pricing norms and may be subject to performance conditions in certain sectors. 2 II. Why Onshore Investors are Pooled in India Resident investors prefer onshore structures for the following reasons: a. The Liberalised Remittance Scheme ( LRS ) issued by the Reserve Bank of India ( RBI ) allows Indian resident individuals to remit abroad up to USD 250,000 per person per financial year for any permissible current or capital account transaction or a combination of both, subject to the restrictions and conditions laid down in the Foreign Exchange Management Act, 1999 ( FEMA ) and related rules and regulations. b. Regulation 7 of the Foreign Exchange Management (Transfer or Issue of any 2. Any downstream investment by an AIF (which receives foreign contributions) will be regarded as foreign investment if the Sponsor and the Investment Manager of the AIF are not Indian owned and controlled. The ownership and control is determined in accordance with the extant FDI Policy. 4

21 Fund Structuring & Operations Legal & Tax Issues Foreign Security) Regulations, 2004 ( ODI Regulations ) stipulates certain conditions to be met by Indian corporations when making investments in an entity outside India engaged in financial services activities (including fund or fund management vehicles). The conditions include, inter alia, that the Indian entity should have earned net profits during the preceding three financial years from the financial services activities; that it is registered with the regulatory authority in India for conducting the financial services activities; and that it has obtained approval from the concerned regulatory authorities, both in India and abroad, for venturing into such financial sector activity. However, as in the case of individual residents, Indian corporates investing abroad into a fund which in turn invests into India could raise round tripping concerns. c. Under a domestic fund structure, the fund vehicle (typically a trust entity registered with SEBI as an AIF) is not to be taxed on any income that is earned from the investments. The income earned is taxable in the hands of the investors when the venture capital fund / AIF distributes the same to the investors. Further, the characterization of income in their hands is the same as that realized / distributed by the investee company to the fund. By contrast, if distributions were to be received in the form of dividend or interest from an offshore fund structure, the Indian resident investors would typically have to recognize the distribution as income and as a result, could be taxed in India (at the time of receipt). III. Which Jurisdictions are Typically Considered for Setting up India- Focused Funds Pooling Offshore Investors A. Mauritius Mauritius continues to remain a favorite destination for overseas investment into Indian corporates, currently accounting for about 35% of total foreign inflows into India. India and Mauritius have shared close economic, political and cultural ties for more than a cen- tury. There has been close cooperation between the two countries on various issues includ-ing trade, investment, education, security and defense. The India-Mauritius DTAA has recently undergone a change through the Protocol signed between India and Mauritius on May 10, Prior to the Protocol, the India-Mauritius DTAA included a provision that exempted a resident of Mauritius from Indian tax on gains derived from the sale of shares of an Indian company. The Protocol now gives India a source based right to tax capital gains which arise from alienation of shares of an Indian resident company acquired by a Mauritian tax resident (as opposed to the previous residence based tax regime under the India-Mauritius DTAA). However, the Protocol provides for grandfathering of investments and the revised position shall only be applicable to investments made on or after April 01, In other words, all existing investments up to March 31, 2017 have been grandfathered and exits / shares transfers in respect of such investments beyond this date will not be subject to capital gains tax in India. Additionally, the Protocol introduces a limitation of benefits provision which shall be a prerequisite for a reduced rate of tax (50% of domestic tax rate) on capital gains arising during a two year transition period from April 01, 2017 to March 31,

22 Provided upon request only The modification on capital gains taxation is limited to gains arising on sale of shares. This ensures continuity of benefit to other instruments and also provides much needed certainty in respect of the position of the India-Mauritius DTAA. The sale of debentures continues to enjoy tax benefits under the India-Mauritius DTAA. That, coupled with the lower withholding tax rate of 7.5% for interest income earned by Mauritius investors from India, comes as big boost to debt investments from Mauritius. Prior to the Protocol, interest income arising to Mauritius investors from Indian securities / loans were taxable as per Indian domestic law. The rates of interest could go as high as 40% for rupee denominated loans to non-fpis. The Protocol amends the DTAA to provide for a uniform rate of 7.5% on all interest income earned by a Mauritian resident from an Indian company. The withholding tax rate offered under the Mauritius DTAA is significantly lower than those under India s treaties with Singapore (15%) and Netherlands (10%). This should make Mauritius a preferred choice for debt investments into India, going forward. Further, the Protocol has introduced a new Article 26A to the India-Mauritius DTAA. It provides that India and Mauritius shall lend assistance to each other in the collection of revenue claims. It allows for Mauritius authorities to enforce and collect taxes of Indian revenue claims, as if such claims were its own, upon a request from Indian revenue authorities On a separate note, the FSC had introduced domestic substance rules to be satisfied by Mauritius based GBC-1 entities after January 01, Based on the new rules, FSC may consider various factors while determining whether a GBC-1 entity is managed and controlled in Mauritius. These include: (i) existence of at least 2 resident directors with relevant expertise, (ii) principal bank account in Mauritius, (iii) accounting records maintained in Mauritius, and (iv)financial statements audited by a local Mauritian auditor. In addition, the FSC may take into account any one of the following criteria: (i) office premise in Mauritius, (ii) at least 1 full time employee in Mauritius, (iii) dispute resolution through arbitration in Mauritius, (iv) assets (excluding cash and shares of GBC-1 company) of at least USD 100,000 in Mauritius, (v) listing on Mauritius stock exchange, and (vi) annual expenditure that is reasonably expected from a similar entity managed and controlled in Mauritius. B. Singapore Singapore is one of the more advanced holding company jurisdictions in the Asia-Pacific region. Singapore possesses an established capital markets regime that is beneficial from the perspective of listing a fund on the Singapore stock exchange. Further, the availability of talent pool of investment professionals makes it easier to employ / relocate productive personnel in Singapore. India saw about USD billion of inflows from Singapore from April 2000 to December 2016, making it the second largest investor in India after Mauritius, accounting for 16% of total FDI received by India. India and Singapore are poised to see enhanced economic cooperation as well as an increase in trade and investment flows. The India-Singapore DTAA, was co-terminus with the India-Mauritius DTAA, hence exemptions under the India-Singapore DTAA would continue to be applicable till such benefits were available under the India-Mauritius DTAA. Subsequent to the India-Mauritius DTAA being amended, India and Singapore signed a protocol on December 30, 2016 to amend the India-Singapore DTAA. The amendments introduced are largely along the lines of those introduced under the India-Mauritius DTAA, wherein the fundamental change was to provide for source base taxation of capital gains arising out of sale of Indian shares held by Singapore residents as opposed to residence based taxation for the same. Singapore does not impose tax on capital gains. Gains from the disposal of investments may however, be construed to be of an income nature and subject to Singapore income tax. Generally, gains on disposal of investments are considered income in nature and sourced in Singapore if they arise from or are otherwise connected with the activities of a trade or 6

23 Fund Structuring & Operations Legal & Tax Issues business carried on in Singapore. As the investment and divestment of assets by the Singapore based entity are managed by a manager, the entity may be construed to be carrying on a trade or business in Singapore. Accordingly, the income derived by the Singapore based entity may be considered income accruing in or derived from Singapore and subject to Singapore income tax, unless the Singaporebased fund is approved under Section 13R and Section 13X respectively of the Singapore Income Tax Act (Chapter 134) ( SITA ) and the Income Tax (Exemption of Income of Approved Companies Arising from Funds Managed by Fund Manager in Singapore) Regulations, Under these Tax Exemption Schemes, specified income derived by an approved company from designated investments managed in Singapore by a fund manager are exempt from Singapore income tax. For fund managers considering Singapore resident structures, a combination of Singapore resident investment funds and Special Purpose Vehicles ( SPV ) can be considered, given the tax exemption schemes and the tax proposals for the companies under the domestic law. The protocol to the India-Singapore DTAA has inserted Article 28A to the DTAA which reads: This Agreement shall not prevent a Contracting State from applying its domestic law and measures concerning the prevention of tax avoidance or tax evasion. The language of the newly inserted Article 28A makes it clear that the GoI sees the GAAR as being applicable even to situations where a specific anti-avoidance provision (such as an LoB clause) may already exist in a DTAA. Interestingly, similar language was not introduced by the protocol to the India-Mauritius DTAA. Making the GAAR applicable to companies that meet the requirements of a LoB clause is likely to adversely impact investor sentiment. C. Ireland Ireland is a tax-efficient jurisdiction when investment into the Indian company is in the form of debt or convertible debt instrument. Interest, royalties and ( FTS ) arising in India and paid to an Irish resident may be subject to a lower withholding tax of 10% under the Ireland- India DTAA. This is a significant relief from the withholding under Indian domestic law which can be as high as 42% for interest and around 27% for royalties and FTS. Ireland can, therefore, be explored for debt funds or real estate funds that provide structured debt and also film funds that provide production financing for motion pictures where cash flows received from distributors could be in the nature of royalties. However, the characterization of income would need to be assessed on a case-by-case basis. However, the changes introduced by the protocols to the India-Mauritius and India-Singapore DTAA on taxation of interest income (as summarized above) make Mauritius and Singapore favorable choice of jurisdictions even for debt funds. The costs of setting-up in Mauritius or Singapore are likely to be less expensive than Ireland. D. Netherlands With its robust network of income tax treaties, Netherlands is an established international fund domicile. In the context of inbound investments to India, Netherlands emerges as an efficient jurisdiction for making portfolio investments. In certain situations, the India-Netherlands DTAA provides relief against capital gains tax in India (that follows a source based rule for taxation of capital gains). Gains arising to a Dutch resident arising from the sale of shares of an Indian company to non-resident buyer would not be taxable in India. However, such gains would be taxable if the Dutch resident holds more than 10% of the shares of the Indian company in case of sale to Indian residents. Even though the eligible holding is capped, the same structure works well for FPIs, who are restricted to participate (whether directly 7

24 Provided upon request only or indirectly or synthetically through offshore derivative instruments or ODIs ) to less than 10% of the paid-up capital of an Indian company. For a Dutch entity to be entitled to relief under the India-Netherlands DTAA, it has to be liable to pay tax in the Netherlands. This may not be an issue for entities such as Dutch limited liability companies (BVs), public companies (NVs) or Cooperatives investing or doing business in India. In the case of KSPG Netherlands 3, it was held that sale of shares of an Indian company by a Dutch holding company to a non-resident would not be taxable in India under the India-Netherlands DTAA. It was further held that the Dutch entity was a resident of the Netherlands and could not be treated as a conduit that lacked beneficial ownership over the Indian investments. The mere fact that the Dutch holding company was set up by its German parent company did not imply that it was not eligible to benefits under the Netherlands-India DTAA. It may be noted that difficulties with respect to treaty relief may be faced in certain situations, especially in the case of general partnerships ( VOF ) and hybrid entities such as closed limited partnerships, European economic interest groupings ( EEIG ) and other fiscally transparent entities. For portfolio investors, the choice of jurisdiction acquires even more importance since the Finance Act, 2014 had revised the Tax Act to crystallize the position that securities held by an FPI will be considered capital assets and the gains derived from their transfer will be considered capital gains. Therefore, funds that have so far been taking a position that such income results in business income, may need to re-visit their structures in order to ensure that they operate from jurisdictions that allow them to obtain relief on paying such tax in India. The Finance Act, 2017 has also introduced an amendment to Section 47 of the ITA to exempt gains arising upon the conversion of preference shares into equity shares from capital gains tax. Among various measures introduced with a view to improve ease of doing business in India, the FM in the Budget speech announced that a common application form for registration, opening of demat accounts and issue of Permanent Account Number ( PAN ) will be introduced for FPIs. GAAR which was introduced in the ITA by Finance Act, 2012 has come into effect from April 1, However, anxiety still exists over the application of GAAR and it still remains unclear on how the Revenue Authorities will practically implement GAAR. IV. Recent Changes The double tax avoidance arrangement of India with Singapore and Mauritius haves undergone a change, as discussed above. Further, several regulatory reforms have been made in India, particularly with respect to foreign investments into AIFs. Investments into Indian companies made by Indian managed and sponsored AIFs with foreign investors will now be deemed domestic investments. 3. [2010] 322 ITR 696 (AAR). 8

25 Fund Structuring & Operations 3. Structural Alternatives for India-Focused Funds Legal & Tax Issues Structuring India-focused Offshore Funds Private equity and venture capital funds typically adopt one of the following three modes when investing into India: (1) direct investment in the Indian portfolio company, (2) direct or indirect investment in an Indian investment fund vehicle, or (3) co-investment along-side the domestic fund vehicle directly in the Indian portfolio company. We explore all three models in the brief below. I. Foreign Investment Regimes India s exchange control regime is set out within the Foreign Exchange Management Act, 1999 ( FEMA ) and the rules and regulations thereunder. FEMA regulates all inbound and outbound foreign exchange related transactions, in effect regulating (or managing) the capital flows coming into and moving out of the country. Subject to certain conditions, such as pricing restrictions, in most industry sectors, if the percentage of equity holding by non-residents does not exceed certain industry-specific thresholds (sectoral caps) then Foreign Direct Investment ( FDI ) does not require prior GoI approval. However, FDI requires prior GoI approval by the Foreign Investment Promotion Board ( FIPB ) if it is in excess of sectoral caps, is in breach of specified conditions or is made in sectors specifically requiring the approval of the FIPB. The GoI has decided to abolish the FIPB in the year This is in line with the comments of the Secretary to the Department of Economic Affairs last year, and the GoI s ushering steps to further ease of doing business. The FM, in his Budget speech, however, added that a road map for the abolition would be introduced over the next few months. The FM also mentioned that further relaxation of the foreign direct investment ( FDI ) regime is under consideration. The RBI is given primary authority to regulate capital flows through the FEMA. Notably, Section 6 of FEMA authorises the RBI to manage foreign exchange transactions and capital flows in consultation with the Ministry of Finance pursuant to the Foreign Exchange Manager (Transfer or Issue of Securities to Persons Resident Outside India) Regulations, 2000 ( TISPRO Regulations ). The primary routes for foreign investment into India are (a) the FDI 4 route, (b) FVCI 5 route and the (c) FPI 6 route. In a bid to simplify and rationalize the FPI regime, SEBI has introduced the Securities and Exchange Board of India (Foreign Portfolio 4. This refers to investments by way of subscription and / or purchase of securities of an Indian company by a non-resident investor. While the RBI allows capital account transactions, these are subject to the Foreign Exchange Management (Transfer or issue of security by a person resident outside India) Regulations 2000 ( TISPRO Regulations issued by the RBI. Thus, direct investments by the offshore fund vehicles / special purpose vehicle (SPV would need to comply with the provisions and restrictions stipulated under the TISPRO Regulations. 5. Given that the FVCI regime has been developed to attract venture capitalists, there are certain incentives attached to being recognised as one. This accordingly requires registration and approval from the regulators (SEBI and RBI). While granting approval to an FVCI, certain restrictions and conditions may be imposed including a restriction on the scope of investments that can be made by the FVCI. The RBI has recently been prescribing in its approval letter to FVCI applicants that the investments by FVCI entities are restricted to select identified sectors (which include, inter alia, infrastructure, biotechnology and IT related to hardware and software development). However, RBI has recently relaxed such sectoral restrictions for investing FVCIs into startups (as defined in the relevant amendment to TISPRO regulations). It is also important to note that SEBI-registered FVCIs are specifically exempted from the RBI pricing guidelines. 6. The recently notified FPI Regulations which repeals the FII Regulations significantly revises the regulation of foreign portfolio investments into India. Under the FPI regime, SEBI has harmonized the FII, sub-account and QFI regimes into a single investor class foreign portfolio investors and provided a single window clearance through DDPs. The FPI Regulations classify FPIs into three categories based on their perceived risk profile. The FPI route as such is the preferred route for foreign investors who want to make portfolio investments and trade in Indian listed stocks on the floor of the stock exchange. 9

26 Provided upon request only Investors) Regulations, 2014 ( FPI Regulations ). Under the FPI Regulations, SEBI has harmonized FIIs, sub-accounts and qualified foreign investors into a single investor class with a view to ensure uniform guidelines and provide a single window clearance for different categories of foreign investors. Each of these inbound investment regimes has been discussed in subsequent chapters.based on the investment strategy and sectoral focus of the concerned fund, the fund could efficiently combine the different investment regimes to make investments in India. The same may require that either the fund itself or an investment holding company obtain registration with SEBI as an FVCI or an FPI. A. Pure Offshore Structure A pure offshore structure is used where there is no intent to pool capital at the domestic (i.e. India) level. Under this structure, a pooling vehicle (Offshore Fund) can be set up in an offshore jurisdiction. Offshore investors will commit capital to the Offshore Fund which in turn will make investments into Indian portfolio companies (under one or more of the inbound investment regimes mentioned above) as and when investment opportunities arise. B. Unified Investment Structure A unified structure is generally used where commitments from both domestic and offshore investors are pooled into a domestic pooling vehicle (Onshore Fund). Alternatively, the unified structure can also be adopted by an India based management team that seeks to extract management fee and carry allocations for the entire structure at the Onshore Fund level. Under this structure, a trust or an LLP or a company (i.e., the Onshore Fund) is organized in India. The domestic investors would directly contribute to the Onshore Fund whereas overseas investors will pool their investments in an offshore vehicle ( Offshore Fund ) which, in turn, invests in the Onshore Fund. The Onshore Fund could be registered with SEBI under the AIF Regulations. The unified structure has received a big boost as general permission has been granted under the FDI Policy to accept foreign investment in an AIF under the automatic route. The following diagram depicts a pure offshore structure: Offshore Investors Subscription Agreement Offshore Fund Management Services Investment Manager Advisory Services Eligible Investments Investment Advisor 10

27 Fund Structuring & Operations Legal & Tax Issues The following diagram depicts a typical unified investment structure: Offshore Investors Subscription Agreement Offshore Fund Onshore Investors Contribution Agreement Contribution Agreement Fund Management Services Investment Manager Eligible Investments C. Co-investment / Parallel Investment Structure A co-investment structure is adopted where the commercial expectation is to raise two separate pools of capital for domestic investors and for offshore investors. Accordingly, separate pooling vehicles will need to be set up in India (i.e. Onshore Fund) and in an offshore jurisdiction (Offshore Fund). The Offshore Fund and the Onshore Fund typically have separate management structures. The Onshore Fund is managed by an India-based investment manager which entity may provide recommendations on investment opportunities to the management of the Offshore Fund on a nonbinding basis. Typically, the co-investment ratio between the Offshore Fund and the Onshore Fund is the ratio of their undrawn capital commitments. The co-investment structure allows independent investments by the Offshore Fund and the Onshore Fund on the basis of their undrawn commitments in case the other runs out of dry powder. Further, it also provides greater flexibility to Onshore Fund allowing it to make investments irrespective of the Offshore Fund s ability to do so. Certain tax risks exist in such a structure. The Onshore Fund and the Offshore Fund may be taxed together in India as an association of persons ( AOP ) and thus, suffer disproportionately higher tax rates. 11

28 Provided upon request only The following diagram depicts a typical co- investment structure: Offshore Investors Subscription Agreement Offshore Fund Management Services Investment Manager Onshore Investors Advisory Services Contribution Agreement Fund Management Services Investment Manager Eligible Instruments II. Certain Tax Risks Owing to the uncertain nature of Indian income-tax laws, there are certain tax risks that may arise to an offshore fund depending on the complexity of the structure and the level of substance demonstrated by the offshore fund. The following is a brief summary of these tax risks: A. Association of Persons (AOP) Risk An AOP is a person recognized under Section 2(31) of the Tax Act and is, therefore, a separate taxable entity. The Supreme Court of India has held that in order to constitute an AOP, persons must join in a common purpose or common action and the object of the association must be to produce income - it is not enough for the persons to receive income jointly. The Court has also held that the question whether there is an AOP must be decided upon the facts and circumstances of each case. The Indian tax authorities may claim that the control and management of an offshore fund vests with 12

29 Fund Structuring & Operations Legal & Tax Issues the domestic investment manager and therefore, the offshore fund and the onshore fund together constitute an AOP. The consequence of constitution of an AOP would primarily be that all assessments would be conducted at the AOP level rather than qua the beneficiaries of the onshore fund. B. Indirect Transfer of Capital Assets Risk An amendment to the Tax Act had introduced a provision for the levy of capital gains tax on income arising from the transfer of shares / interest in a company / entity organized outside India which derives, directly or indirectly, its value substantially from the assets located in India. Pursuant to the said amendment, there is a possibility that Indian tax authorities may seek to tax the transfer of the shares in an offshore fund by investors outside India, or the redemption of shares by investors, notwithstanding that there is no transfer taking place in India, on the basis that the shares of the offshore fund derive substantial value from India. However, Central Board of Direct Tax s ( CBDT ) through Circular no. 4 of 2015 ( 2015 Circular ) has clarified that an distribution of dividends by an offshore company with the effect of underlying Indian assets would not result in a tax liability since it does not result in indirect transfer of shares that derive their value substantially out of India. The Finance Act, 2017 brought changes to clarify that the indirect transfer tax provisions shall not be applicable to an asset or capital asset that is held directly/ indirectly by way of investment in a Category I or Category II FPI. This resolves concerns for a class of offshore funds which are registered as a category I or category II FPIs as redemptions by investors at the level of the fund shall not be subject to the indirect transfer taxation. Further, in multitiered structures, if the entity investing into India is a Category I or Category II FPI, any up-streaming of proceeds by way of redemption / buyback will not be brought within the Indian tax net. The provisions also exclude, from applicability of the indirect transfer tax provisions, situations where any redemptions or re-organizations or sales result in capital gains by investors in Category I or Category II FPIs. The clarifications are applicable retrospectively from FY starting April 1, 2012, and therefore should help bring about certainty on past transactions that have been entered into by Category I and Category II FPI entities. The amendment has left out a large chunk of the affected sector i.e. Category III FPIs, PE and VC investors investing in Indian securities. During the Indian Union Budget speech for the financial year (the Budget ), the Finance Minister indicated that further clarifications will be issued with respect to redemptions or buybacks of shares or interests in any foreign company (having underlying Indian investments) as a result of or arising out of the redemption or sale of Indian securities which are chargeable to Indian taxes would be exempt from the applicability of the indirect transfer tax provisions. While the text of the Finance Act, 2017 did not stipulate this, a separate clarification may be issued as stated by the Finance Minister in the Budget speech. C. General Anti-avoidance Rule ( GAAR ) Risk A statutory GAAR has come into effect from the financial year beginning on April 01, GAAR, as it is currently drafted, empowers tax authorities to disregard or combine or re-characterize any part or whole of a transaction / arrangement such that the transaction / arrangement gets taxed on the basis of its substance rather than its form if such arrangement gets classified as an impermissible avoidance arrangement. This could result in any tax benefit being denied, including denial of DTAA benefits, shifting of residency of investors and / or re-characterization of capital gains income as any other classification. The CBDT has recently clarified by way of a circular 7 that shares issued after March 7. CBDT Circular No.7 of 2017 dated January 27,

30 Provided upon request only 31, 2017 upon the conversion of compulsorily convertible preference shares ( CCPS ) acquired prior to April 01, 2017 should be grandfathered if the terms of the conversion were finalized at the time of issuance of the CCPS. D. Tax Exposure Owing to Permanent Establishment In a unified investment model or a parallel investment model, there could be a risk of the onshore fund or the Indian investment manager of the onshore fund being perceived to constitute a permanent establishment of the offshore fund if there is no evidence of independent decisionmaking at the offshore fund level. The Finance Act, 2015 had changed the criteria for determining tax residence of companies incorporated outside India. As per the amended criteria, to ensure that the company is not construed to be tax resident of India in a particular financial year, the company s place of effective management or POEM in that financial year should not be located in India. POEM has been defined to mean a place where key management and commercial decisions that are necessary for the conduct of the business of an entity as a whole are, in substance made. On December 23, 2015 the Indian tax authorities released draft guidance for determining POEM of a company. The draft guidance emphasizes that the test of POEM is one of substance over form and will depend on facts and circumstances of each case. Further, the draft guidance contemplates different tests for companies with active and passive businesses outside India. The POEM for an active company is presumed to be outside India if the majority of its board meetings are held outside India. To determine the POEM of passive companies, the persons who actually make key management and commercial decisions for the business as a whole will be identified, followed by identifying the place where decisions are actually taken. However, it is essential to note that the tax authorities have received a significant amount of critical feedback from various stakeholders and the same is expected to be considered before a final version of guidance is released. POEM has also come into effect from April 01,

31 Fund Structuring & Operations Legal & Tax Issues 4. Alternative Investment Funds in India I. Introduction Before the emergence of the Venture Capital Private Equity ( VCPE ) industry in India, entrepreneurs primarily depended on private placements, public offerings and lending by financial institutions for raising capital. However, given the considerations involved, these were not always the optimal means of raising funds. Following the introduction of the Securities and Exchange Board of India (Venture Capital Funds) Regulations ( VCF Regulations ) in 1996, the VCPE industry successfully filled the gap between capital requirements of fast-growing companies and funding available from traditional sources such as banks, IPOs, etc. The VCPE industry has also had a positive impact on various stakeholders providing much needed risk capital and mentoring to entrepreneurs, improving the stability, depth and quality of companies in the capital markets, and offering riskadjusted returns to investors. The growth in Venture Capital ( VC ) funding in India can be attributed to various factors. Once the GoI started becoming more and more aware of the benefits of the VC investments and the criticality for the growth of the different sectors such as software technology and internet, favorable regulations were passed regarding the ability of various financial institutions to invest in a VCF. Further, tax treatments for VCFs were liberalized and procedures were simplified. Subsequently, in 2012, SEBI took steps to completely overhaul the regulatory framework for domestic funds in India and introduced the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 ( AIF Regulations ). Among the main reasons cited by SEBI to highlight its rationale behind introducing the AIF Regulations was to recognize AIFs as a distinct asset class; promote start-ups and early stage companies; to permit investment strategies in the secondary markets; and to tie concessions and incentives to investment restrictions. Here it is relevant to note that SEBI has adopted a practical grandfathering approach which provides that funds that are already registered under the VCF Regulations would continue to be governed by those regulations including for the purpose of raising commitments up to their targeted corpus. However, existing venture capital funds are not permitted to increase their targeted corpus. Further, new funds and existing funds that are not registered under any regime would need to be registered under the AIF Regulations. II. Alternative Investment Funds Subject to certain exceptions, the ambit of the AIF Regulations is to regulate all forms of vehicles set up in India for pooling of funds on a private placement basis. To that extent, the AIF Regulations provide the bulwark within which the Indian fund industry is to operate. An AIF means any fund established or incorporated in India in the form of a trust or a company or an LLP or a body corporate which: a. is a privately pooled investment vehicle which collects funds from investors, whether Indian or foreign, for investing it in accordance with a defined investment policy for the benefit of its investors; and b. is not covered under the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996, Securities and Exchange Board of India (Collective Investment Schemes) Regulations, 1999 or any other regulations of the Board to regulate fund management activities. 15

32 Provided upon request only III. Choice of Pooling Vehicle The AIF Regulations contemplate the establishment of funds in the form of a trust, a company, an LLP or a body corporate. The following table provides a comparison of these entities from an investment fund perspective: 8 Issue Trust Limited Liability Partnership Company General The person who reposes or declares the confidence is called the author of the trust 8 ; the person who accepts the confidence is called the trustee ; the person for whose benefit the confidence is accepted is called the beneficiary ; the subject matter of the trust is called trust property ; the beneficial interest or interest of the beneficiary is the right against the trustee as owner of the trust property; and the instrument, if any, by which the trust is declared is called the instrument of trust / indenture of trust The concept of LLP was recently introduced in India under the Limited Liability Act, 2008 ( LLP Act ). An LLP is a hybrid form of a corporate entity, which combines features of an existing partnership firm and a limited liability company (i.e. the benefits of limited liability for partners with flexibility to organize internal management based on mutual agreement amongst the partners). The functioning of an LLP is governed by the LLP agreement. A Company can be incorporated under the Companies Act, The control of the company is determined by its board of directors which is elected by the shareholders. Separate classes of securities could be issued to different shareholders that shall determine their rights and obligations (as distinct from other classes) from both, the voting perspective as well as from a distribution perspective. The class structure, however, would need to be in compliance with Companies Act, 2013, as and when all relevant sections thereof are brought into effect. Entities Involved The Settlor: The Settlor settles a trust with an initial settlement. Terms of the indenture of trust ( Indenture ) shall administer the functioning of the trust ( Trust ). The Trustee: The Trustee is in charge of the overall administration of the Trust and may be entitled to a trusteeship fee. The Trustee may also appoint an investment manager, who in turn manages the assets of the Trust and the schemes / funds as may be launched under such Trust from time to time. The Contributor: The contributor is the investor to the Trust (the Fund) and makes a capital commitment under a contribution agreement. Partner: A partner represents an investor in the fund. To that extent, a partner has an obligation to fund its commitment to the fund and is entitled to distributions based on fund documents (being the LLP Agreement in this case). Designated Partner: Though the expression designated partner is not explicitly defined, however, on a plain reading of the LLP it is understood that such designated partner shall be the person responsible and liable in respect of the compliances stipulated for the LLP. Shareholders: Shareholders hold the shares of the company and are granted special privileges depending on the class of shares they own. Directors: Directors have a fiduciary duty towards the company with respect to the powers conferred on them by the Companies Act and by the Memorandum of Association and Articles of Association of the company. They are trustees in respect of powers of the company that are conferred upon them, for instance, powers of (a) issuing and allotting shares; (b) approving transfers of shares; (c) making calls on shares; and (d) forfeiting shares for non-payment of call etc. They must act bona fide and exercise these powers solely for the benefit of the company. 8. Commonly referred to as a settlor. 16

33 Fund Structuring & Operations Legal & Tax Issues Management of entities The Trustee is responsible for the overall management of the Trust. In practice this responsibility is outsourced to an investment manager pursuant to an investment management agreement. The LLP relies on the Designated Partner in this respect. In practice, this responsibility may be outsourced to an investment manager pursuant to an investment management agreement. The board of directors manages the company involved. In practice this responsibility is outsourced to an investment manager pursuant to an investment management agreement. Market Practice Almost all funds formed in India use this structure. The regulatory framework governing trust structures is stable and allows the management to write its own standard of governance. Only a few funds are registered under this structure. The Registrar of Companies ( RoC ) does not favor providing approvals to investment LLPs. As per section 5 of the LLP Act, 2008, only an individual or a body corporate is eligible to be a partner in an LLP. There are no clear precedents for raising funds in a company format. The following diagram depicts an AIF that is set up in the form of a trust: Investors Sponsor Contribution Agreement Contribution Agreement (sponsor commitment) Fund Management Services Investment Manager Eligible Investments 17

34 Provided upon request only IV. Classification of AIFs As mentioned previously in our introductory chapter, the AIF Regulations were introduced with the objective of effectively channelizing incentives. For this purpose, the AIF Regulations define different categories of funds with the intent to distinguish the investment criteria and relevant regulatory concessions that may be allowed to them. A description of the various categories of AIFs along with the investment conditions and restriction relevant to each category is summarized below: a. AIFs may invest in securities of companies incorporated outside India subject to such conditions / guidelines that may be stipulated by SEBI or the RBI; b. Co-investment in an investee company by a Manager / Sponsor should not be on more favourable terms than those offered to the AIF; c. Only a specific percentage of the investible funds (25% for Category I and II AIFs and 10% for Category III AIFs) can be invested in a single investee company; Category I AIF Category II AIF Category III AIF i. Category I AIFs are funds with strategies to invest in start-up or early stage ventures or social ventures or SMEs or infrastructure or other sectors or areas which the government or regulators consider as socially or economically desirable. ii. Under the AIF Regulations, the following funds are designated as sub- categories of Category I AIFs - venture capital funds, SME funds, social venture funds, infrastructure funds and such other AIFs as may be specified. In September 2013, SEBI introduced angel investment funds as a sub-class of the venture capital fund sub- category. iii. AIFs which are generally perceived to have positive spillover effects on the economy and therefore, SEBI, the Government of India or other regulators may consider providing incentives or concessions shall be classified as Category I AIFs. i. Category II AIFs are funds which cannot be categorized as Category I AIFs or Category III AIFs. These funds do not undertake leverage or borrowing other than to meet day-to-day operational requirements and as permitted in the AIF Regulations. ii. AIFs such as private equity funds or debt funds for which no specific incentives or concessions are given by the Government of India or any other regulator are included in the Category II AIF classification. i. Category III AIFs are funds which employ complex or diverse trading strategies and may employ leverage including through investment in listed or unlisted derivatives. ii. AIFs such as hedge funds or funds which trade with a view to make short-term returns or such other funds which are open ended and for which no specific incentives or concessions are given by the Government of India or any other regulator are included in the Category III AIF classification. V. Investment Conditions and Restrictions under the AIF Regulations The AIF Regulations prescribe a general set of investment restrictions that are applicable to all AIFs and further prescribe a specific set of investment restrictions that are applicable for each category of AIFs. SEBI is authorized to specify additional criteria or requirements as may be required. The following is the list of general investment conditions applicable to all AIFs: d. AIFs should not invest in associates except with the approval of 75% of investors by value of their investments in the AIF; and e. The un-invested portion of the investible funds may be invested in liquid mutual funds or bank deposits or other liquid assets of higher quality such as Treasury Bills, Collateralized Borrowing and Lending Obligations ( CBLOs ), commercial papers, certificates of deposits, etc. till deployment of funds as per the investment objective. 18

35 Fund Structuring & Operations Legal & Tax Issues The following table summarizes the investment restrictions that are applicable in respect of the various categories of AIFs: Investment Restrictions and Conditions for AIFs Category I AIFs i. Category I AIFs shall invest in investee companies or venture capital undertakings or in special purpose vehicles or in limited liability partnerships or in units of other AIFs specified in the Regulations. ii. A Category I AIF of a particular sub-category may invest in the units of the same sub-category of Category I AIFs. However, this investment condition is subject to the further restriction that Category I AIFs are not allowed to invest in the units of Fund of Funds. iii. Category I AIFs shall not borrow funds directly or indirectly or engage in leverage except for meeting temporary funding requirements for more than thirty days, on not more than four occasions in a year and not more than 10% of its investible funds. In addition to these investment conditions, the AIF Regulations also prescribe a set of investment conditions in respect of each sub-category of Category I AIFs. Category II AIFs i. Category II AIFs shall invest primarily in unlisted investee companies or in units of other AIFs as may be specified in the placement memorandum; ii. Category II AIFs may invest in the units of Category I and Category II AIFs. This is subject to the restriction that Category II AIFs cannot invest in the units of Fund of Funds; iii. Category II AIFs shall not borrow funds directly or indirectly or engage in leverage except for meeting temporary funding requirements for more than thirty days, on not more than four occasions in a year and not more than 10% of its investible funds; iv. Category II AIFs may engage in hedging subject to such guidelines that may be prescribed by SEBI; v. Category II AIFs may enter into an agreement with a merchant banker to subscribe to the unsubscribed portion of the issue or to receive or deliver securities in the process of market making under Chapter XB of the ICDR Regulations; and vi. Category II AIFs shall be exempt from Regulations 3 and 3A of the Insider Trading Regulations in respect of investments in companies listed on SME exchange or SME segment of an exchange pursuant to due diligence of such companies. This is subject to the further conditions that the AIF must disclose any acquisition / dealing within 2 days to the stock exchanges where the investee company is listed and such investment will be locked in for a period of 1 year from the date of investment. Category III AIFs i. Category III AIFs may invest in securities of listed or unlisted investee companies or derivatives or complex or structured products; ii. Category III AIFs may invest in the units of Category I, Category II and Category III AIFs. This is subject to the restriction that Category III AIFs cannot invest in the units of Fund of Funds; iii. Category III AIFs engage in leverage or borrow subject to consent from investors in the fund and subject to a maximum limit as may be specified by SEBI; and iv. Category III AIFs shall be regulated through issuance of directions by SEBI regarding areas such as operational standards, conduct of business rules, prudential requirements, restrictions on redemption and conflict of interest. VI. Key Themes under the AIF Regulations A. Continuing Interest The AIF Regulations require the sponsor or the manager of an AIF to contribute a certain amount of capital to the fund. This portion is known as the continuing interest and will remain locked-in the fund until distributions have been made to all the other investors in the fund. For a Category I or Category II AIF, the sponsor or the manager is required to have a continuing interest of 2.5% of the corpus of the fund or INR 50 million whichever is lower and in the case of a Category III AIF, a continuing interest of 5% of the 19

36 Provided upon request only corpus or INR 100 million whichever is lower. For the newly introduced angel investment funds, the AIF Regulations require the sponsor or the manager to have a continuing interest of 2.5% of the corpus of the fund or INR 5 million whichever is lower. Further, the sponsor or the manager (as the case may be) is required to disclose its investment in an AIF to the investors of the AIF. B. Minimum Corpus The AIF Regulations prescribe that the minimum corpus for any AIF shall be INR 200 million ( Minimum Corpus ). Corpus is the total amount of funds committed by investors to the fund by way of written contract or any such document as on a particular date. By its circular dated on June 19, 2014, SEBI requires that where the corpus of an open-ended scheme falls below the Minimum Corpus (post redemption(s) by investors or exits), the Fund Manager is given a period of 3 months to restore the Minimum Corpus, failing which, all the interests of the investors will need to be mandatorily redeemed. C. Minimum Investment The AIF Regulations do not permit an AIF to accept an investment of less than INR 10 million crore ( Minimum Investment Amount ) from any investor unless such investor is an employee or a director of the AIF or an employee or director of the manager of the AIF in which case the AIF can accept investments of a minimum value of INR 2.5 lakhmillion. The Circular has specifically clarified that in case of an open-ended AIF, the first lump-sum investment received from an investor should not be less than the Minimum Investment Amount. 9 Further, in case of partial redemption of units by an investor in an open- ended AIF, the amount of investment retained by the investor should not fall below the Minimum Investment Amount. 10 D. Qualified Investors The AIF Regulations permit an AIF to raise funds from any investor whether Indian, foreign or non-resident through the issue of units of the AIF. E. Foreign investment in AIFs The RBI has issued a notification dated November 16, Notification No. FEMA 355/2015-RB ( November Notification ) as an amendment to TISPRO Regulations. In terms of the November Notification, foreign investments into an AIF are allowed under the automatic route and the Notification classifies downstream investment by an AIF as foreign investment only if the sponsor and/or the investment manager are not Indian owned and controlled. Prior to the Notification, foreign investments in AIFs required a specific approval from the FIPB and the downstream investments by such AIFs were also governed by the FDI Policy. However, the November Notification seemed to prohibit LLPs from acting as the sponsor or manager to an AIF. Subsequently, by a notification dated February 15, 2016 ( February Notification ) 12, RBI has clarified the position by permitting LLPs to act as the sponsor or manager of an AIF if they are Indian owned and controlled. As per the notification, an LLP shall be considered to be Indian owned and controlled if:- a. More than 50% of the investment in such an LLP is contributed by resident Indian citizens and / or entities which are ultimately owned and controlled by resident Indian citizens; and b. Such residents have a majority of the profit share. Further, the February Notification also states that for the purposes of an LLP, control shall mean the right to appoint majority of designated partners, where such designated partners, with specific exclusion to others, have control over all the policies of the LLP. 9. CIR/IMD/DF/14/ Ibid. 11. Notification No. FEMA 355/2015-RB 12. Notification No. FEM 362/2016-RB) 20

37 Fund Structuring & Operations Legal & Tax Issues In addition to the above, the RBI had issued another notification dated February 16, which states that investments by NRIs under Schedule 4 of TISPRO Regulations will be deemed to be domestic investment at par with the investment made by residents. F. Maximum Number of Investors The AIF Regulations caps the maximum number of investors for an AIF at 1,000. G. Private Placement The AIF Regulations prohibit solicitation or collection of funds except by way of private placement. While the AIF Regulations do not prescribe any thresholds or rules for private placement, guidance is taken from the Companies Act, H. Tenure While Category I and Category II AIFs can only be closed-end funds, Category III AIFs can be open- ended. The AIF Regulations prescribe the minimum tenure of 3 years for Category I and Category II AIFs. SEBI, vide its circular dated October 01, 2015 (CIR/ IMD/DF/7/2015), clarified that the tenure of any scheme of the AIF shall be calculated from the date of the final closing of the scheme. Further, the tenure of any AIF can be extended only with the approval of 2/3rd of the unit-holders by value of their investment in the AIF. I. Overseas investments by AIFs stipulated by the RBI in this respect. Investments would be made only in those companies which have an Indian connection (i.e. company which has a front office overseas, while back office operations are in India) and such investments would be up to 25% of the investible funds of the AIF. The aforementioned circular clarifies that an offshore VCU means a foreign company whose shares are not listed on any of the recognized stock exchange in India or abroad. Such an investment by an AIF requires prior approval from SEBI. The allocation of investment limits would be done on a first come-first serve basis depending on availability in the overall limit of USD 500 million, and in case an AIF fails to make the allocated investment within a period of 6 months from date of approval, SEBI may allocate such unutilized limit to another applicant. J. Change in Circumstances The Circular provides that in case any material change to the placement memorandum (changes that SEBI believes to be significant enough to influence the decision of the investor to continue to be invested in the AIF), is said to have arisen in the event of (1) change in sponsor / manager, (2) change in control of sponsor / manager, (3) change in fee structure which may result in higher fees being charged to the unit holders and (4) change in fee structure or hurdle rate which may result in higher fees being charged to the unit holders. In case of such material change, the existing investors who do not wish to continue post the change shall be provided with an exit option and such existing investors will be provided not less than one month for indicating their dissent. As per a circular dated October 1, 2015 issued by SEBI, an AIF may invest in equity and equity-linked instruments of off-shore VCUs, subject to certain conditions mentioned in this circular such as an overall aggregate limit of USD 500 million for all AIFs and VCFs registered under the SEBI (Venture Capital Funds) Regulations, 1996 and the guidelines 13. Notification No. 362/2016-RB 21

38 Provided upon request only VII. Taxation of Alternative Investment Funds A. Taxation of funds registered as Category I or Category II AIFs In response to a long-standing demand of the investment funds industry in India, the Finance Act, 2015, extended tax pass through status to AIFs that are registered with SEBI as Category I AIFs or Category II AIFs under the AIF Regulations. Prior to the changes introduced by the Finance Act, 2015, only an AIF that was registered as a venture capital fund sub-category of Category I and venture capital funds registered under the VCF Regulations were eligible for the exemption under section 10(23FB) of the Tax Act. The Finance Act, 2015 included a proviso to section 10(23FB) of the Tax Act pursuant to which, Category I and Category II AIFs that are registered under the AIF Regulations, will be taxed according to the new rules set forth in the newly introduced Chapter XII-FB of the ITA. Consequently, VCFs registered under the erstwhile VCF Regulations will continue to be eligible to claim the exemption under section 10(23FB) in respect of income from investments in venture capital undertakings. The Finance Act, 2015 defines an investment fund to mean a fund that has been granted a certificate of registration as a Category I or a Category II AIF and provides that any income accruing or arising to, or received by, a unit-holder of an investment fund out of investments made in the investment fund shall be chargeable to income- tax in the same manner as if it were the income accruing or arising to, or received by such person, had the investments made by the investment fund been made directly by the unit- holder. 14 In other words, the income of a unit-holder in an investment fund will take the character of the income that accrues or arises to, or is received by the investment fund. However, the Act contemplates that income chargeable under the head Profits and gains of business and profession will be taxed at the investment fund level and the tax obligation will not pass through to the unit- holders. In order to achieve this, the Act introduces two provisions: a. Section 10(23FBA) which exempts income of an investment fund other than income chargeable under the head Profits and gains of business or profession ; and b. Section 10(23FBB) which exempts the proportion of income accruing or arising to, or received by, a unit-holder of an investment fund which is of the same nature as income chargeable under the head Profits and gains of business or profession. Where the total income of an investment fund in a given previous year (before making adjustments under section 10(23FBA) of the ITA) is a loss under any head of income and such loss cannot be, or is not wholly, set-off against income under any other head of income, the Finance Act, 2015 allows such loss to be carried forward and set-off in accordance with the provisions of Chapter VI (Aggregation of Income and Set Off or Carry Forward of Loss). Furthermore, the Finance Act, 2015 provides that the loss will not pass through to the unit holders of an investment fund and accordingly, the unit holders will be precluded from offsetting their proportionate loss from the investment fund against other profits and gains that they may have accrued. This is unlike under the rules for taxation for a trust, where a trust is regarded as being a determinate trust or where an investor s contribution to the trust is regarded as a revocable transfer, in which case the investor retains the ability to off-set its proportionate losses against its other profits and gains. 14. Explanation 1 to Section 115UB of the Income Tax Act,

39 Fund Structuring & Operations Legal & Tax Issues Furthermore, the CBDT has notified 15 that income received by investment funds would be exempted from TDS by portfolio companies. This should be helpful in case of interest / coupon payouts by portfolio companies to such funds. Previously, it was administratively difficult for investors to take credit of the TDS withheld by portfolio companies. An important feature of the pass-through framework was the requirement to deduct tax at 10% on the income that is payable to the payee as outlined in the newly section 194LBB of the Tax Act. In view of the rule mandating the deemed credit of income to the accounts of unit-holders, the Finance Act, 2015 extended the requirement to deduct tax to scenarios where income is not actually paid or credited but only deemed to be credited. While the pass-through regime was a welcome development, it was not without its set of difficulties. For example, the withholding provision applied to exempt income such as dividends and long-term capital gains on listed equity shares. Further, no clarity has been provided on whether the withholding obligation would also apply in respect of non-resident investors who were eligible to DTAA benefits. The Finance Act, 2016 has amended section 194(LBB) of the Tax Act to enable deduction of withholding tax for non-residents at a rate which is in accordance with the provisions of the DTAA if they are eligible to DTAA benefits. However, it keeps the withholding rate unchanged for resident investors. The only relief that is available to resident investors is that they are allowed to approach the revenue authorities for a reduced or a nil withholding certificate under section 197 of the Tax Act if they are entitled to any benefits as per their tax status or due to the stream of income that is being distributed by the investment fund. For example:- if the investment fund is only distributing dividends it should be allowed to obtain a nil withholding certificate as such income is exempt from tax in the hands of the investor. Furthermore, CBDT vide a press release dated May 5, 2016 has clarified that it has given directions to officers 15. Vide Notification No. 51 / 2015 dated June, 2015 in relation to determining the tax treatment of income arising from transfer of unlisted shares wherein it has decided that income arising from transfer of unlisted shares would be taxed as capital gains under the ITA irrespective of the period of holding. This would however, not be applied in situations where (i) the genuineness of transactions in unlisted shares itself is questionable; or (ii) the transfer of unlisted shares is related to an issue pertaining to lifting of corporate veil; or (iii) the transfer of unlisted shares is made along with the control and management of underlying business and the Indian revenue authorities would take appropriate view in such situations. In this regard, CBDT has issued a subsequent clarification dated January 24, 2017 (CBDT F.No.225/12/2016/ITA.II) stating that the exception to transfer of unlisted securities made along with control and management of underlying business would not apply to Category I & II AIFs. B. Taxation of Category III AIFs As mentioned earlier, AIFs are usually set up as trusts and consequently they are subject to the tax framework that is applicable to trusts in India. Under Indian tax law, a trust is not a separate taxable entity. Taxation of trusts is laid out in sections 161 to 164 of the Tax Act. Where the trust is specific, i.e., the beneficiaries are identifiable with their shares being determinate, the trustee is assessed as a representative assessee and tax is levied on and recovered from them in a like manner and to the same extent as it would be leviable upon and recoverable from the person represented by them. In the case of AIG (In Re: Advance Ruling P. No. 10 of 1996), it was held that it is not required that the exact share of the beneficiaries be specified for a trust to be considered a determinate trust, and that if there is a pre- determined formula by which distributions are made the trust could still be considered a determinate trust. The tax authorities can alternatively raise an assessment on the beneficiaries directly, but in no case can the tax be collected twice over. While the income tax officer is free to levy tax either on the beneficiary or on the trustee in their capacity as representative assessee, as per section 161 of the Tax Act, it must be done in the same manner and to the same 23

40 Provided upon request only extent that it would have been levied on the beneficiary. Thus, in a case where the trustee is assessed as a representative assessee, they would generally be able to avail of all the benefits / deductions etc. available to the beneficiary, with respect to that beneficiary s share of income. There is no further tax on the distribution of income from a trust. Further, the CBDT has issued a clarification (vide Circular No. 6 of 2016 dated February 29, 2016) that income arising from transfer of listed shares and securities, which are held for more than 12 months should be taxed as capital gains under the ITA unless the tax-payer itself treats these as its stock-in-trade and transfer thereof as its business income. On July 28, 2014, CBDT issued a circular to provide clarity on the taxation of AIFs that are registered under the AIF Regulations.The Circular states that if the names of the investors or their beneficial interests are not specified in the trust deed on the date of its creation, the trust will be liable to be taxed at the maximum marginal rate. The Bangalore Income Tax Appellate Tribunal in the case of DCIT v. India Advantage Fund VII 16 held that income arising to a trust where the contributions made by the contributors are revocable in nature, shall be taxable at the hands of the contributors. The ruling comes as a big positive for the Indian fund industry. The ruling offers some degree of certainty on the rules for taxation of domestic funds that are set up in the format of a trust by regarding such funds as fiscally neutral entities. Globally, funds have been accorded pass through status to ensure fiscal neutrality and investors are taxed based on their status. This is especially relevant when certain streams of income maybe tax free at investor level due to the status of the investor, but taxable at fund level. Funds, including AIFs that are not entitled to pass through status from a tax perspective (such as Category III AIFs) could seek to achieve a pass through basis of tax by ensuring that the capital contributions made by the contributors is on a revocable basis). 16. ITA No.178/Bang/

41 Fund Structuring & Operations Legal & Tax Issues 5. Trends in Private Equity The standard of what constitutes an alignment of interests between fund investors (LPs) and fund managers (GPs) of an India-focused fund or an Indiabased fund has undergone some degree of change over the years. Typically, LP participation in a fund is marked by a more hands-on approach in discussing and negotiating fund terms which by itself is influenced by a more comprehensive due diligence on the track record of the GP and the investment management team. As discussed briefly earlier, unified structures have emerged as a preferred choice for structuring India focused funds. There is also an increased participation from DFIs in India focused funds, including unified structures. Accordingly, some global benchmarks need to be followed when designing the structure and calibrating the fund documents including the governance, fiduciary aspects and adherence to ESG policies. There can be variations of a unified structure depending on the investment strategy of the fund, allocation of economics for the GP and certain legal and regulatory considerations involving the LPs. In addition to the above, there can be other variations to the investment structure depending on the commercials involved. The overseas fund could directly invest in India based opportunities or adopt a co-investment structure (i.e. the offshore fund invests alongside the Indian fund in eligible investment opportunities). The FDI Policy will however be applicable to investments made directly by an offshore fund in India based investments. An optimum structure should reconcile the investment strategy, team economics and LP preferences. This chapter provides a brief overview of favorable reasons for a unified structure and certain fund terms that have been carefully negotiated between LPs and GPs in the Indian funds context (specifically in case of unified structures). I. Favorable reasons for a unified structure (a) Non- applicability of foreign investment restrictions: Under the unified structure, investments made by the Indian AIF with the capital contributions received from the offshore fund shall also be deemed to be domestic investments if the manager and sponsor of the AIF are Indian owned and controlled. Therefore, the restrictions placed on foreign investments such as FDI Policy related restrictions including (a) sector specific caps (b) choice in instruments being limited to equity shares, fully, compulsorily convertible debentures and fully, compulsorily and mandatorily convertible preference (c) optionality clauses being subject to conditions (d) pricing guidelines, etc. shall not be applicable to the investments made in India through the unified platform (which would have been otherwise applicable in respect of investments directly made by the offshore fund in Indian opportunities). (b) Consolidation of corpus: A unified structure allows aggregation of the asset-under-management across both the offshore fund and the Indian AIF. A larger corpus at the Indian AIF level will help tap more capital from those LPs whose commitments are linked to the corpus of the Indian AIF and allow the manager to evaluate larger deals as the portfolio concentration requirements can be met using the larger aggregate pool at the AIF level. In this regard, it is important to understand the differences between pooling offshore investors directly into the Indian AIF versus a unified structure. There is a consolidation of corpus in both the cases, however, there are other reasons for pooling offshore investors in an offshore vehicle (i.e. unified structure) which are summarized below: (i) In case of direct investment by offshore investors in the Indian AIF, each offshore investor may be required 25

42 Provided upon request only to obtain a PAN 17 card from Indian income tax authorities and file income tax returns in India; (ii) While making distributions to offshore investors under the direct structure, the AIF has to consider withholding tax rates in force between India and the concerned country of each of the relevant offshore investor. In case of the feeder set up, the tax status of the feeder is to be considered. (c) Tax pass-through and DTAA eligibility: Category I and Category II AIFs have been accorded tax pass through status under the Indian Income Tax Act, 1961, i.e. the income received by a unit-holder through the AIF will be chargeable to income-tax in the same manner as if it were the income arising to such unit-holder directly by the unit-holder. 18 Accordingly, the tax liabilities of the offshore fund will remain the same (as would be for direct investments) under the unified structure. The protocols to the India-Mauritius DTAA and India-Singapore give India the right to tax capital gains arising from the transfer of equity shares. Despite the changes introduced by the protocols, Mauritius and Singapore continue to be favorable jurisdictions from a tax perspective as Mauritius and Singapore would continue to have the right to tax capital gains arising from the transfer of non-convertible debentures, compulsorily convertible debentures and optionally convertible debentures (depending on the terms of the conversion of the optionally convertible debentures). (d) Favorable regime: The GoI wants to promote onshore fund management activities. To that end, the benefits which are being made available to AIFs would also extend to the offshore fund in a unified structure. (e) Decision-making: Under the unified structure, the offshore fund will make a principal investment-related decision i.e. whether or not to invest in the Indian AIF. The offshore fund may need to make additional decisions if certain offshore / Indian investments are required to be made directly by the offshore fund. Since most of the decisions in respect of the Indian AIF are to be taken by the India based investment manager, risks such as that of the offshore fund having a permanent establishment or its place of effective management ( POEM ) 19 in India, are reduced. II. Trending fund terms A. Investment Committee and Advisory Board Sophisticated LPs insist on a robust decision- making process whereby an investment manager will refer investment and / or divestment proposals along with any due diligence reports in respect of such proposals to an investment committee comprising representatives of the LPs as well as the GP. The investment committee is authorized to take a final decision in respect of the various proposals that are referred to it. In view of this, the composition of the investment committee and the nature of rights granted to certain members can become very contentious. The committee is also empowered to monitor the performance of investments made by the fund on an on-going basis. Separately, any transaction that could involve a potential conflict of interest is expected to be referred for resolution to an 17. The term PAN stands for Permanent Account Number. 18. S. 115UB read with s. 10(23FBA), s. 10(23FBB) and s. 194LBB of the Indian Income Tax Act, With amendments brought about by the Finance Act, 2015 (the 2015 Act ) in relation to the criteria for determining the tax residence of companies incorporated outside India, a foreign company should not be a tax resident of India in a particular financial year if the company s POEM in that financial year is not located in India. POEM has been defined to mean a place where key management and commercial decisions that are necessary for the conduct of the business of an entity as a whole are, in substance, made. The effective date of this amendment has been pushed by one year by the Finance Act, Accordingly, the said change should be relevant for foreign companies from the financial year

43 Fund Structuring & Operations Legal & Tax Issues advisory board consisting of members who are not associated with the GP. B. Management Fee and Carried Interest Keeping up with the global trend, there appears to be less tolerance among India-focused LPs to invest in a fund that provides a standard 2-20 fee carry model. Since management fee bears no positive correlation to the performance of the investments made by the fund, LPs can be circumspect about the fee percentage. Further, issues may arise with respect to the base amount on which the management fee is computed. During the commitment period, fee is calculated as a percentage of the aggregate capital commitments made to a fund. After the commitment period, fee is calculated as a percentage of the capital contribution that has not yet been returned to the LPs. The fee percentage itself is generally a function of the role and responsibilities expected to be discharged by a GP. It is not uncommon to see early stage capital and VCFs charging a management fee that is marginally higher than the normal. Recently, LPs have requested that the management fee after the commitment period be charged on the amount of unreturned capital contribution which has been invested and not on the amounts utilized towards expenses or management fees. In certain situations, a unified structure allows flexibility to the GP team to extract its economics (fee and carried interest allocations) at either the Indian AIF level only or also at the offshore fund level.. However, it is important to ensure that the overall agreed maximum cap for the carried interest as well as management fees is not breached across the platform. C. Expenses LPs express concern with respect to the kind of expenses that are charged to the fund (and by extension, to their capital contributions). With a view to limiting the quantum of expenses that are paid by the fund, LPs insist on putting a cap on expenses. The cap is generally expressed as a percentage of the size of the fund or as a fixed number can become a debatable issue depending on the investment strategy and objective of the fund. GPs often try to negotiate for annual caps for operating expenses, given the long tenure of VC/PE funds and the difficulty in ascertaining the appropriate cap for the entire tenure upfront; whereas, LPs prefer a cap for the entire tenure to be disclosed upfront in the fund documents. If an annual cap method is chosen, LPs often seek the right to be consulted before setting the annual cap by GPs. Separately, as a measure of aligning interests, LPs insist that allocations made from their capital contributions towards the payment of expenses should be included while computing the hurdle return whereas the same should not be included while determining management fee after the commitment period. D. Waterfall A typical distribution waterfall involves a return of capital contribution, a preferred return (or a hurdle return), a GP catch-up and a splitting of the residual proceeds between the LPs and the GP. With an increasing number of GPs having reconciled themselves to the shift from the 20% carried interest normal, a number of innovations to the distribution mechanism have been evolved to improve fundraising opportunities by differentiating product offerings from one another. Waterfalls have been structured to facilitate risk diversification by allowing LPs to commit capital both on a deal-bydeal basis as well as on a blind pool basis. Further, distribution of carried interest has been structured on a staggered basis such that the allocation of carry is proportionate to the returns achieved by the fund. In a unified structure, the distribution waterfall at the Indian AIF level may require that distributions to the Offshore Fund be grossed-up to the extent of the expenses incurred at the Offshore Fund level. The distribution proceeds at the Indian AIF level could be allocated between the domestic investors 27

44 Provided upon request only and the offshore fund providing them INR and USD denominated preferred returns respectively E Giveback While there have been rare cases where some LPs have successfully negotiated against the inclusion of a giveback provision, GPs in the Indian funds industry typically insist on an LP giveback clause to provide for the vast risk of financial liability including tax liability. The LP giveback facility is a variant to creating reserves out of the distributable proceeds of the fund in order to stop the clock / reduce the hurdle return obligation. With a view to limiting the giveback obligation, LPs may ask for a termination of the giveback after the expiry of a certain time period or a cap on the giveback amount. However, this may not be very successful in an Indian context given that the tax authorities are given relatively long time-frames to proceed against taxpayers. As bespoke terms continue to emerge in LP-GP negotiations, designing a fund may not remain just an exercise in structuring. The combination of an environment less conducive for fund raising and changes in legal, tax and regulatory environment along with continuously shifting commercial expectations requires that fund lawyers provide creatively tailored structural alternatives. F. Voting rights In a unified structure, the Indian AIF will issue different classes of units / shares (as applicable) to the domestic LPs and the offshore fund respectively upon receiving their capital contributions. In respect of issues where a vote is required to be cast by the offshore fund in its capacity as an investor in the Indian AIF, the board of the offshore fund may seek the recommendations of its shareholders (i.e. the offshore investors) on such matters and cast votes on the units / shares (as applicable) of the Indian AIF in a manner reflective of that and in keeping with their fiduciary obligations. G. USD-INR hurdle rates In a unified structure, the Indian AIF may either offer (i) an INR hurdle rate to all its investors, whether Indian or foreign; or (ii) an INR hurdle rate to Indian investors and a USD hurdle rate to foreign investors. Commitments by the Indian investors and the offshore fund to the Indian AIF will be denominated and drawn down in Indian Rupees and commitments by the offshore investors to the offshore fund will be denominated and drawn down in US Dollars. This exposes the corpus of the Indian fund to exchange rate fluctuations which impacts the ratio of unfunded capital commitments among Indian investors and offshore investors. There are a variety of options available to deal with the exchange rate fluctuations in a unified structure, depending on the commercial expectations. The exchange rate ratio may either be fixed from the date of the first closing itself, or may be closed at the time of final closing, as no further commitments will be expected after the final closing into the Indian AIF. If there are certain unfunded commitments remaining at either the offshore fund level or the Indian AIF level due to currency fluctuations while the other vehicle s unfunded capital commitments have reduced to nil (in case the GP is unable to align the ratio of drawdown between the two pools of investors with the exchange rate fluctuation), then the commitment period of the relevant vehicle may be terminated at the discretion of the manager / advisor (as applicable). Alternatively, with the approval of the requisite investors, such remaining capital commitments may also be utilized. H. Co-investment Opportunities In a unified structure, offering of co-investment rights to LPs of the offshore fund needs to be designed carefully to allow efficient implementation. 28

45 Fund Structuring & Operations Legal & Tax Issues I. Side-letter items Typically, investors may seek differential arrangements with respect to management fee, co-investment allocation, membership to LPACs etc. An investor may also insist on including a most favored nation (or MFN) clause to prevent any other investor being placed in a better position than itself. It is relevant for all investors that the Indian AIF is able to effect the terms entered into by investors whether directly at the Indian AIF level or the offshore fund, including making available rights under MFN provisions. J. Closing Adjustments A common fund term in all private equity funds requires closing adjustments to be made when a new investor is admitted to the fund at any closing subsequent to the first closing. In a unified structure, a new investor in the offshore fund would be required to compensate the existing investors at the offshore fund level as well as the Indian AIF level and viceversa for a new investor participating subsequent to the first closing in the Indian AIF. 29

46 Provided upon request only 6. Fund Documentation Fund counsels are now required to devise innovative structures and advise investors on terms for meeting investor s (LP) expectations on commercials, governance and maintaining discipline on the articulated investment strategy of the fund. All these are to be done in conformity with the changing legal framework. To attract high quality LPs, it is essential that the fund documents (including the investor pitch and the private placement memorandum) include an articulation on the fund s governance standard. It is also essential that global best practices are taken into account when preparing such fund documents including contribution agreements, LP side letters and closing opinion, and to ensure that the same are not just confined to Indian regulatory and tax aspects. Fund documents are an important aspect of the fundraising exercise. They are also critical to determine whether a pooling vehicle is in compliance with the applicable law across various jurisdictions. For an India-focused fund or a fund with India allocation which envisages LP participation both at the offshore level and at the Indian level, the following documents are typically prepared: I. At the Offshore Fund level A. Private Placement Memorandum / Wrapper The private placement memorandum ( PPM ) is a document through which the interests of the fund are marketed to potential investors. Accordingly, the PPM outlines the investment thesis of a fund, summarizes the key terms on which investors could participate in the fund s offering and also presents the potential risk factors and conflicts of interest that could arise to an investor considering an investment in the fund. A wrapper is a short supplement that is attached to the PPM of a domestic fund (in case of unified structure ) to help achieve compliance with the requirements for private placement of the securities / interests of an offshore fund to investors in jurisdictions outside India. The use of a wrapper is common in the case of unified investment structures as the risks of the onshore fund are inherent in the shares / LP interests issued to investors to the offshore fund. B. Constitution A constitution is the charter document of an offshore fund in certain jurisdictions. It is a binding contract between the company (i.e. the Fund), the directors of the company and the shareholders (i.e. the investors) of the company. C. Subscription Agreement The subscription agreement is an agreement that records the terms on which an investor will subscribe to the securities / interests issued by an offshore fund. The subscription agreement sets out the investor s capital commitment to the fund and also records the representations and warranties made by the investor to the fund. This includes the representation that the investor is qualified under law to make the investment in the fund. 20 D. Advisory Agreement The board of an offshore fund may delegate its investment management / advisory responsibilities to a separate entity known as the Investment Advisor or the Investment Manager. The Investment 20. In case the fund is set up in the format of a limited partnership, this document would be in the format of a limited partnership agreement (with the general partner holding the management interests). 30

47 Fund Structuring & Operations Legal & Tax Issues Advisory Agreement contains the general terms under which such investment advisor renders advise in respect of the transactions for the Fund s board. Sometimes, the investment advisor / manager of an offshore fund enters into a sub-advisory agreement with an on-the-ground investment advisory entity (the sub-advisor). The sub-advisory agreement typically provides that the sub-advisor will provide non-binding investment advice to the investment advisor of the offshore fund for remuneration. II. At the Onshore Fund level A. Private Placement Memorandum AIF Regulations require that a concerned fund s PPM should contain all material information about the AIF, including details of the manager, the key investment team, targeted investors, fees and other expenses proposed to be charged from the fund, tenure of the scheme, conditions or limits on redemption, investment strategy, risk factors and risk management tools, conflicts of interest and procedures to identify and address them, disciplinary history, terms and conditions on which the manager offers services, affiliations with other intermediaries, manner of winding up the scheme or the AIF and such other information as may be necessary for an investor to make an informed decision as to whether to invest in the scheme of an AIF. SEBI has now directed fund managers to add by way of an annexure to the placement memorandum, a detailed tabular example of how the fees and charges shall be applicable to the investor and the distribution waterfall for AIFs. 21 AIFs should also include disciplinary actions in its PPM. 22 It has been clarified by SEBI that AIFs should also include a disciplinary history of the AIF, sponsor, 21. Paragraph 2(a)(i)of the SEBI Circular CIR/IMD/DF/14/ Regulation 11(2) AIF Regulations. manager and their directors, partners, promoters and associates and a disciplinary history of the trustees or the trustee company and its directors if the applicant for AIF registration is a trust. 23 Any changes made to the PPM submitted to SEBI at the time of the application for registration as an AIF must be listed clearly in the covering letter submitted to SEBI and further to that, such changes must be highlighted in the copy of the final PPM. 24 In case the change to the PPM is a case of a material change (factors that SEBI believes to be a change significantly influencing the decision of the investor to continue to be invested in the AIF), said to arise in the event of (1) change in sponsor / manager, (2) change in control of sponsor / manager, (3) change in fee structure or hurdle rate which may result in higher fees being charged to the unit holders), existing unit holders who do not wish to continue post the change shall be provided with an exit option. 25 This change is critical for fund managers to note. Such disclosure reduces the space for views being taken by a fund manager in a given liquidity event leading to distribution. This also requires that the fund manager engages more closely with the fund counsel to articulate the waterfall in a manner that they can actually implement with a degree of automation. Any deviance from the waterfall as illustrated in the fund documents could potentially be taken up against the fund manager. B. Indenture of Trust The Indenture of Trust is an instrument that is executed between a settlor and a trustee whereby the settlor conveys an initial settlement to the trustee towards creating the assets of the fund. The Indenture of Trust also specifies the various functions and responsibilities to be discharged by the appointed trustee. It is an important instrument from an Indian income - tax perspective since the formula for computing beneficial interest is specified. 23. Paragraph 2(a)(ii) of the SEBI Circular CIR/IMD/DF/14/2014Regulation. 24. Paragraph 2(b)(i) of the SEBI Circular CIR/IMD/DF/14/ Paragraph 2(b)(iv)(a) of the SEBI Circular CIR/IMD/DF/14/

48 Provided upon request only The formula for computing beneficial interest is required to establish the determinate nature of the trust and consequently for the trust to be treated as a pass-through entity for tax purposes. C. Investment Management Agreement The Investment Management Agreement is to be entered into by and between the trustee and the investment manager (as the same may be amended, modified, supplemented or restated from time to time). Under this Agreement, the trustee appoints the investment manager and delegates all its management powers in respect of the fund (except for certain retained powers that are identified in the Indenture of Trust) to the investment manager. D. Contribution Agreement The Contribution Agreement is to be entered into by and between each contributor (i.e. investor), the trustee and the investment manager (as the same may be amended, modified, supplemented or restated from time to time) and, as the context requires. The Contribution Agreement records the terms on which an investor participates in a fund. This includes aspects relating to computation of beneficial interest, distribution mechanism, list of expenses to be borne by the fund, powers of the investment committee, etc. A careful structuring of this document is required so that the manager / trustee retain the power to make such amendments to the agreement as would not amend the commercial understandings with the contributor. respect to management fee, distribution mechanics, participation in investment committees, investor giveback, etc. An investor may also insist on including a most favoured nation ( MFN ) clause to prevent any other investor being placed in a better position than itself. An issue to be considered is the enforceability of such side letters unless it is an amendment to the main contribution agreement itself. IV. Agreements with Service Providers Sometimes, investment managers may enter into agreements with placement agents, distributors and other service providers with a view to efficiently marketing the interests of the fund. These services are offered for a consideration which may be linked to the commitments attributable to the efforts of the placement agent / distributor. III. Investor Side Letters It is not uncommon for some investors to ask for specific arrangements with respect to their participation in the fund. These arrangements are recorded in a separate document known as the side letter that is executed by a specific investor, the fund and the investment manager. Typically, investors seek differential arrangements with 32

49 Fund Structuring & Operations Legal & Tax Issues 7. Hedge Funds Hedge funds lack a precise definition. The term has been derived from the investment and risk management strategies they tend to adopt. The Indian regulators comfort in allowing access to global hedge funds is of recent origin. It was only gradually that several investment opportunities were opened for investors participating under the FII Regulations that allowed for a wider gamut of strategy implementation for a hedge fund. The FPI Regulations have been in effect from June 01, This section deals with eligible participants under the FPI Regulations, the range of investment and hedge strategies that may be adopted and the scope of dealing with contract notes (swaps and offshore derivative instruments, i.e. ODIs). On the onshore side, SEBI allows hedge strategies as a possible investment strategy that a Category III AIF could adopt. This section also deals with the basic framework within which such onshore hedge funds are allowed to operate. I. FPI Regulations Under the FPI regime, SEBI has harmonized foreign institutional investors, sub-accounts and qualified foreign investors regimes into a single investor class foreign portfolio investors and provided a single window clearance through designated depository participants ( DDP ). With each investor registering directly as an FPI (under the respective three categories discussed later), the sponsored sub accounts structure seems to be over. The FPI Regulations put into effect, several recommendations made by the Committee on Rationalization of Investment Routes and Monitoring of Foreign Portfolio Investments ( Committee ) chaired by Mr. K.M. Chandrasekhar in The key recommendations of the Committee were to combine the erstwhile portfolio investment categories of FIIs, sub- accounts and QFIs into a single investor class of FPIs. The other significant proposal pertained to the establishment of a self-regulatory mechanism for registration and monitoring of FPIs, which will be overseen by the DDP rather than directly by SEBI. The Committee s report was submitted on June 12, 2013 to SEBI. After considering the recommendations of the Committee, on January 07, 2014, SEBI notified the FPI Regulations. Subsequently, SEBI has also vide a Circular dated January 08, 2014, issued operating guidelines for DDPs. With the notification of the FPI Regulations, the FII Regulations stand repealed. A. Meaning of FPI The term FPI has been defined to mean a person who satisfies the eligibility criteria prescribed under the FPI Regulations and has been registered under the FPI Regulations. No person is permitted to transact in securities as a FPI unless it has obtained a COR granted by the DDP on behalf of SEBI. An existing FII / Sub- Account holding a valid COR shall be deemed to be an FPI till the expiry of the block of three years for which fees have been paid under the FII Regulations. In respect of entities seeking to be registered as FPIs, DDPs are authorized to grant registration on behalf of SEBI with effect from June 01, The application for grant of registration is to be made to the DDP in a prescribed form along with the specified fees. The eligibility criteria for an FPI, interalia, include: 26. SEBI Circular CIR/IMD/FIIC/6/2014 dated March 28, 2014, para 4(a). 33

50 Provided upon request only i. The applicant is a person not resident in India 27 ; ii. The applicant is resident of a country whose securities market regulator is a signatory to the International Organization of Securities Commission s Multilateral Memorandum iii. of Understanding or a signatory to a bilateral Memorandum of Understanding with the SEBI; iv. The applicant is not residing in a jurisdiction identified by the Financial Action Task Force (FATF): a. as having strategic Anti-Money Laundering deficiencies; or iv. The applicant being a bank 28, is a resident of a country whose Central bank is a member of Bank for International Settlements; v. The applicant is not a non-resident Indian; vi. The applicant is a fit and proper person as per the SEBI (Intermediaries) Regulations, A certificate of registration granted by a DDP shall be permanent unless suspended or cancelled by SEBI or surrendered by the FPI. A DDP may grant conditional registration, subject to fulfilment of specified conditions. 29 For example, a conditional registration may be granted to an entity with a validity period of 180 days, to achieve the broad based criteria as required to qualify as a Category II FPI. b. combating the Financing of Terrorism deficiencies; or c. as not having made significant progress in addressing the deficiencies or not committed to an action plan developed with the FATF to address the deficiencies. 27. The term persons, non-residents and resident used herein have the same meaning as accorded to them under the Tax Act. 28. In case of an applicant being a bank or its subsidiary, the DDP is required to forward the details of the applicant to SEBI who would in turn request the RBI to provide its comments. The comments of the RBI would be provided by the SEBI to the DDP. 29. One of the conditions include that the applicant is an India dedicated fund or undertakes to make investment of at least 5% corpus of the fund in India. 34

51 Fund Structuring & Operations Legal & Tax Issues B. Categories of FPI The FPI Regulations classify FPIs into three categories based on their perceived risk profile. An outline of the three categories is given below: Category Category I FPI Category II FPI Category III FPI Eligible Foreign Portfolio Government and Government related i. Appropriately regulated broad based funds 30 ; Includes all eligible FPIs who are not eligible under Category Investors investors such as central banks, Governmental ii. Appropriately regulated persons 31 ; I and II, such as endowments, charitable soci- eties, charitable trusts, foundations, corporate agencies, sovereign wealth funds or iii. Broad-based funds that are not appropriately regulated 32 ; bodies, trusts, individuals and family offices. internation- al and multilateral organizations or agencies. iv. University funds and pension funds; and v. University related endowments already registered with SEBI as FIIs or sub-accounts In relation to a Category II FPI, appropriately regulated means regulated or supervised in same capacity in which it proposes to make investments in India. 33 In order to find out whether an entity is regulated in the same capacity, the DDP has the option of verifying if the FPI is allowed by its regulator to carry out such activity under its license / registration granted by the regulator. 34 If an FPI ceases to meet the eligibility requirements for a particular category, then it will be reclassified under another appropriate category and the FPI shall be required to provide the DDP with additional KYC documents. Fresh purchases would not be allowed until the additional documents are forwarded but the FPI will be allowed to sell the securities already purchased by it Includes mutual funds, investment trusts, and insurance / reinsurance companies. 31. Includes banks, asset management companies, investment managers / advisors, portfolio managers. 32. This is subject to the fact that the investment manager of such broad based fund is regulated and undertakes that it will be responsible for the acts, omissions and other things done by the underlying broad-based funds. 33. Explanation 1 to Regulation 5(b) of the FPI Regulations. 34. SEBI, FPI FAQs, Question SEBI Circular CIR/IMD/FIIC/02/2014 dated January 08, C. Status of Existing FIIs / Sub- Accounts and Rollover to FPI Regime As discussed above, the FPI Regulations provide that any FII / or a sub-account which holds a valid ertificate of registration shall be deemed to be an FPI until the expiry of the block of three years for which fees has been paid as per the FII Regulations. In other words, existing FIIs or sub-accounts will be deemed to be FPIs under the FPI Regulations. 36 Further, the FPI Regulations provide that existing FIIs or sub-accounts can continue to buy, sell or deal in securities till the expiry of their registrations (as FIIs and sub-accounts respectively) or until such earlier time when the existing FIIs or sub-accounts make payment of the applicable conversion fee for converting into FPIs. 37 The FPI Regulations prescribe a conversion fee of USD 1,000 payable by the existing FII or sub-account to SEBI Regulation 2(1)(h) r/w Regulation 2(1)(g) of the FPI Regulations. 37. Proviso to Regulation 3(1) of the FPI Regulations. 38. Part A of the Second Schedule of the FPI Regulations. 35

52 Provided upon request only In cases where an FII has multiple proprietor sub- accounts and one of them chooses to convert as FPI, then the conversion of all other sub-accounts of that FII to FPI will follow. This requirement applies only when the proprietary sub-account is the one being converted, in case of other sub-accounts, the remaining sub-accounts (whether proprietary or broad-based) do not have to convert. 39 If an entity engages Multiple Investment Management ( MIM ) structure, then it is allowed to obtain multiple registrations with SEBI and these applicants will be required to appoint the same local custodian For the purposes of investment limits, these multiple registrations will be clubbed and the same position will continue in the FPI regime. 41 Investment limits will be monitored at the investor group level by the depositories based on the information provided by DDPs and necessary information will be shared between the depositories. 42 Also, a fund which has NRIs as investors will not be barred from obtaining registration as a Category II FPI under the FPI regime (as was the case in the FII regime). 43 D. Broad Based Criteria Under the erstwhile FII Regulations, a broad-based fund meant a fund, established or incorporated outside India which has at least 20 investors with no individual investor holding more than 49% of the shares or units of the fund. It was also provided that if the broad-based fund had any institutional investor, it was not necessary for such fund to have 20 investors. Further, any institutional investor holding more than 49% of the shares or units of the fund would have to itself satisfy the broad based criteria Regulation 3(1) of the FPI Regulations. 40. A custodian means a person who has been granted a certificate of registration to carry on the business of custodian of securities under the Securities and Exchange Board of India (Custodian of Securities) Regulations, SEBI, FPI FAQs, Question SEBI, FPI FAQs, Question SEBI, FPI FAQs, Question Explanation 2 to Regulation 5 Under the FPI regime, every fund, sub-fund or share class needs to separately fulfill the broad based criteria where a segregated portfolio is maintained. Therefore, where a newly added class of shares is not broad-based then the FPI will have to provide an undertaking to the DDP that the new class will become broad-based within 90 days from the date of DDP approval letter. 45 The FPI Regulations continue to follow the broadbased criteria with two notable deviations. One, in order to satisfy the broad-based criteria, it would be necessary for a fund to have 20 investors even if one of the investors is an institutional investor. Two, for the purpose of computing the number of investors in a fund, both direct and underlying investors (i.e. investors of entities that are set up for the sole purpose of pooling funds and making investments) shall be counted. An FPI, who has a bank as an investor will be deemed to be broad based for the purposes of FPI Regulations as was the case in the FII regime. 46 E. Investments The FPI Regulations provide that investment in the issued capital of a single company by a single FPI or an investor group shall be below 10% of the total issued capital of the company. 47 The FPI Regulations further provide that in case the same set of ultimate beneficial owner(s) invests through multiple FPI entities, such FPI entities shall be treated as part of the same investor group and the investment limits of all such entities shall be clubbed at the investment limit as applicable to a single FPI. 48 As per the Operational Guidelines for Designated Depository Participants (Operational Guidelines) released by SEBI, for the purpose of ascertaining an investor group, the concerned DDPs shall consider all such entities having direct or indirect common shareholding / beneficial ownership / beneficial interest of more than 50% 45. SEBI, FPI FAQs, Question Regulation 5(b) of the FPI Regulations. 47. Regulation 21(7) of the FPI Regulations. 48. Regulation 23(3) of the FPI Regulations. 36

53 Fund Structuring & Operations Legal & Tax Issues as belonging to same investor group. 49 The investment limit of 10% and clubbing of investments has also been made applicable to offshore derivative instruments, as explained subsequently in this chapter. Further, FPIs are allowed to offer cash or foreign sovereign securities with AAA rating or corporate bonds or domestic government securities, as collateral to the recognized stock exchanges for their transactions in the cash as well as derivative segment of the market, subject to norms specified by RBI, SEBI and Clearing Corporations. 50 Under the FPI Regulations, FPIs are permitted to invest in the following: a. shares, debentures and warrants of companies, unlisted, listed or to be listed on a recognized stock exchange in India, through primary and secondary markets; b. units of schemes floated by domestic mutual funds listed on a recognized stock exchange in India; c. units of scheme floated by a Collective Investment Scheme; d. derivatives traded on a recognized stock exchange; e. dated government securities; f. rupee denominated credit enhanced bonds; g. security receipts issued by asset reconstruction companies; h. perpetual debt instruments and debt capital instruments, as specified by the Reserve Bank of India from time to time; i. listed and unlisted non-convertible debentures / bonds issued by an Indian company in the infrastructure sector, where infrastructure is defined in terms of the extant External Commercial Borrowings (ECB) guidelines; 49. Paragraph 4.2 of the Operational Guidelines. 50. SEBI Circular CIR/MRD/DRMNP/9/2013, March 20, j. non-convertible debentures or bonds issued by Non-Banking Financial Companies (NBFCs) categorized as Infrastructure Finance Companies (IFCs) by the Reserve Bank of India; k. rupee denominated bonds or units issued by infrastructure debt funds; l. Indian depository receipts; m. Unlisted non-convertible debentures / bonds issued by an Indian company subject to the guidelines issued by the Ministry of Corporate Affairs, GoI from time to time; n. Securitized debt instruments including as specified in the FPI Regulations and o. such other instruments specified by SEBI from time to time. In respect of investments in the secondary market, the following additional conditions shall apply 51 : An FPI shall transact in the securities in India only on the basis of taking and giving delivery of securities purchased or sold except in the following cases: a. any transactions in derivatives on a recognized stock exchange; b. short selling transactions in accordance with the framework specified by SEBI; c. any transaction in securities pursuant to an agreement entered into with the merchant banker in the process of market making or subscribing to unsubscribed portion of the issue in accordance with Chapter XB of the Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2009; d. any other transaction specified by SEBI. The Reserve Bank of India (RBI,) through a circular dated February 03, 2015, has introduced conditions for foreign portfolio investors (FPIs) to make future investments in and redeem corporate 51. Regulation 21(4) of the FPI Regulations. 37

54 Provided upon request only bonds. The circular has introduced the following changes: a. FPIs will be allowed to invest only in corporate bonds which have a minimum residual maturity of three years. b. FPIs will be prohibited from investing in corporate bonds with optionality clauses exercisable before three years have elapsed. c. FPIs will not be subject to a lock-in period and will be free to sell corporate bonds, including those with a maturity of less than three years, to domestic investors. FPIs will not be allowed to make any further investment in liquid and money market mutual fund schemes. As per the recent changes introduced by the RBI in the TISPRO Regulations, 52 FPIs can also invest in the units of an investment vehicle; where investment vehicle shall mean an entity registered and regulated under the relevant regulations framed by SEBI or any other authority designated for the purpose and shall include REITs governed by the SEBI (REITs) Regulations, 2014, InvITs governed by the SEBI (InvITs) Regulations, 2014 and Alternative Investment Funds governed by the SEBI (AIFs) Regulations, 2012; and unit shall mean beneficial interest of an investor in the investment vehicle (as defined above) and shall include shares or partnership interests. F. Protected Cell Companies Prior to December 2013, there was a blanket ban on protected cell companies ( PCC ), segregated portfolio companies ( SPC ) or equivalent structures which used to ring-fence assets and liabilities under law from participating under the FII/FPI route. Based on the representations made by our firm, SEBI had provided that entities that apply for registration under the FPI Regulations shall not be regarded as having an opaque structure if they are required by their regulator or under any law to ring fence their assets and liabilities from other funds / sub-funds in the entity. This applied for structures such as open-ended investment companies ( OEIC ) in the UK. OEICs are typically set up in the format of umbrella companies that have several sub funds. Recent amendments to the OEIC regulations in the UK required that a PCC structure be adopted to ring fence liabilities between these sub-funds. Opaque structures are not allowed to register as FPIs under the FPI regime and FPI applicants will have to submit declaration and undertakings to that effect. If an FPI s regulator or any law requires it to ring fence its assets and liabilities from other funds or sub- funds then an FPI applicant will not be considered as an opaque structure merely for this reason and would be eligible to be registered as an FPI, provided it meets the following criteria: a. the FPI applicant is regulated in its home jurisdiction; b. each fund or sub-fund in the applicant satisfies broad-based criteria; and c. the applicant has given an undertaking to provide information about its beneficial owners, if asked for it by SEBI. 53 G. Tax Treatment of FPI Investments The tax treatment of FPIs registered under the FPI Regulations would be similar to the treatment accorded to FIIs. Accordingly, all such FPIs would be deemed to be Foreign Institutional Investors under Explanation (a) to section 115AD and would be taxed similarly. The Tax Act with effect from April, 2015 states that securities held by an FPI will be considered capital assets, and gains derived from their transfer will be considered capital gains. As a result of this amendment, gains arising on disposal / transfer of a range of listed securities including shares, 52. Notification No. FEMA 362 / RB 53. SEBI Circular CIR/IMD/FIIC/21/2013 dated December 19,

55 Fund Structuring & Operations Legal & Tax Issues debentures and eligible derivative instruments as may have been acquired under applicable laws, shall be taxed as capital gains (and not business income) under Indian domestic law. The characterization has been a long standing point of contention under Indian tax law. This is because, under Indian tax treaties, the business income of a non-resident is not taxable in India unless the non- resident has a permanent establishment in India. In comparison, capital gains are generally taxable unless the non-resident invests through a favourable DTAA jurisdiction such as Mauritius, Singapore or Cyprus (till the effect of the recently introduced protocol sets in). While revenue authorities have tended to treat the income of FPI as capital gains on this account, the position has undergone much litigation in the past. Further, Finance Act, 2017 has exempted gains made with respect to investments into Category I and Category II FPIs from indirect transfer tax provisions. II. Participatory Notes and Derivative Instruments A.Overview Participatory Notes ( P-Notes ) are a form of Offshore Derivative Instruments ( ODI ). Section 2(1)(j) of the SEBI Foreign Portfolio Investors Regulations, 2014 provides that an offshore derivative instrument means any instrument, by whatever name called, which is issued overseas by a foreign portfolio investor against securities held by it that are listed or proposed to be listed on any recognised stock exchange in India, as its underlying. P-Notes are issued by FIIs (and eligible FPIs). The FPI Regulations specifically exclude Category- III FPIs and certain Category-II FPIs (those that are unregulated broad-based funds who rely on their investment managers to obtain registration as Category-II FPIs), from issuing, subscribing or otherwise dealing in ODIs. 54 ODIs can only be issued (a) to those persons who are regulated by an appropriate foreign regulatory authority; and (b) after compliance with know your client norms. Accordingly, an FII (or an eligible FPI) seeking to issue ODIs to any person must be satisfied that such person meets these two tests. 55 Therefore, to be perceived / classified as reportable ODIs, the concerned offshore contracts would need to refer to an Indian underlying security and also be hedged in India to whatever extent by the issuer FII / FPI. Accordingly, unless so hedged, an ODI remains a contract note, that offers its holder a return linked to the performance of a particular underlying security but need not be reported under the disclosure norms set out under the FPI Regulations. It is the issuing FII / FPI that engages in the actual purchase of the underlying Indian security as part of its underlying hedge to minimize its risks on the ODI issued. The position of the ODI holder is usually that of an unsecured counterparty to the FII / FPI (with inherent counterparty risks amongst others) and under the ODI (the contractual arrangement with the issuing FII / FPI) the holder of a P-Note is only entitled to the returns on the underlying security with no other rights in relation to the securities in respect of which the ODI has been issued. The FPI Regulations provide that Category I FPIs and Category II FPIs (which are directly regulated by an appropriate foreign regulatory authority) 56 are permitted to issue, subscribe to and otherwise deal in ODIs. However, those Category II FPIs which are not directly regulated (which are classified as Category- II FPIs by virtue of their investment manager being appropriately regulated) and all Category-III FPIs are not permitted to issue, subscribe to or deal in ODIs. 54. Regulation 22 of the FPI Regulations. 55. Ibid. 56. Reference may be made to Explanation 1 to Regulation 5 of the FPI Regulations, where it is provided that an applicant (seeking FPI registration) shall be considered to be appropriately regulated if it is regulated by the securities market regulator or the banking regulator of the concerned jurisdiction in the same capacity in which it proposes to make investments in India. 39

56 Provided upon request only As compared to the FII regime, two differences emerge, (1) unregulated broad based funds are not eligible to subscribe to ODIs, even if they are managed by an appropriately regulated person (which, under the FII Regulations, were eligible to hold ODIs) and, (2) entities that qualify as regulated broad based funds, may also issue ODIs under the FPI Regulations. FPIs shall have to fully disclose to SEBI, any information concerning the terms of and parties to ODIs entered into by it relating to any securities listed or proposed to be listed in any stock exchange in India. On November 24, 2014, SEBI issued a circular1( Circular ) aligning the conditions for subscription of ODIs to those applicable to FPIs. The Circular makes the ODI subscription more restrictive. As per the Circular, read with the FPI Regulations, to be eligible to subscribe to ODI positions, the subscriber should be regulated by an International Organization of Securities Commissions ( IOSCO ) member regulator or in case of banks subscribing to ODIs, such bank should be regulated by a Bank for International Settlements ( BIS ) member regulator. It states that an FPI can issue ODIs only to those subscribers who meet certain eligibility criteria mentioned under regulation 4 of the FPI Regulations (which deals with eligibility criteria for an applicant to obtain registration as an FPI) in addition to meeting the eligibility criteria mentioned under regulation 22 of the FPI Regulations. Accordingly, ODIs can now only be issued to those persons who (a) are regulated by an appropriate foreign regulatory authority ; (b) are not resident of a jurisdiction that has been identified by Financial Action Task force ( FATF ) as having strategic Anti-Money Laundering deficiencies; (c) do not have opaque structures (i.e. PCCs / segregated portfolio companies ( SPCs or equivalent structural alternatives); and (d) comply with know your client norms. The Circular clarifies that opaque structures (i.e., PCCs / SPCs or other ring-fenced structural alternatives) would not be eligible for subscription to ODIs. The Circular further requires that multiple FPI and ODI subscriptions belonging to the same investor group would be clubbed together for calculating the below 10% investment limit. The existing ODI positions will not be affected by the Circular until the expiry of their ODI contracts. However, the Circular specifies that there will not be a rollover of existing ODI positions and for any new ODI positions, new contracts will have to be entered into, in consonance with the rules specified in the Circular. 57 SEBI has recently issued a circular 58 ( ODI KYC Circular ) to bring about uniformity and increase the transparency among ODI issuers for adopting systems and procedures to comply with the conditions mentioned under the FPI Regulations. The ODI KYC Circular requires that ODI issuers put in place necessary controls, systems and procedures with respect to ODIs to comply with the updated compliance requirements. These systems will undergo a periodical review and evaluation by the ODI issuers. As per the ODI KYC Circular, ODI issuers shall now be required to identify and verify the beneficial owners (on a look through basis) in the subscriber entities, who hold in excess of 25% in case of a company and 15% in case of partnership firms / trusts / unincorporated bodies. ODI issuers shall also be required to identify and verify the person(s) who control the operations when no beneficial owner is identified basis the materiality threshold stated above. SEBI has also given the format of KYC documentation to be followed by ODI issuers while obtaining such documentation from the ODI subscribers in respect of their beneficial owners nda-hotline/nda-hotline-single-view/article/sebi-rewrites-rules- on-offshore- derivative-instruments-odi.html?no_ cache=1&- chash=60c81c4a0fcc1c1ffbbe8d2aae5e2e5b. 58. CIR/IMD/FPI&C/59/2016 dated June 10,

57 Fund Structuring & Operations Legal & Tax Issues In addition to the initial KYC done at the time of on-boarding, the ODI issuers will be required to review the KYC for each client (a) once every three years for low-risk clients; and (b) every year for all other clients. The risk profile of the clients for this purpose will be done by the ODI issuers. Further, the ODI KYC Circular requires that any ODI subscriber shall take prior consent of the ODI issuer for transferring the ODIs and such transfer shall be made only to persons in accordance with Regulation 22(1) of the FPI Regulations. In addition to compliance with the above, ODI issuers will be required to file suspicious transaction reports, if any, with the Indian Financial Intelligence Unit, in relation to the ODIs issued by it in accordance with the Prevention of Money Laundering Act, These reports are submitted when the reporting entity identifies a suspicious transaction in accordance with the Prevention of Money Laundering Act, 2002 and the rules made thereunder. Further, SEBI has decided to insert an express provision in the FPI Regulations to prevent NRIs or the entities which are beneficially owned NRIs from subscribing to ODIs (SEBI Board Meeting Minutes dated April 26, 2017). Prior to the decision made by SEBI on April 26, 2017, there was no express prohibition on entities which are beneficially owned by NRIs from subscribing to ODIs. FII Returns on underlying portfolio Counterparty (holder of ODI) Investment holdings to hedge exposures under the ODI as issued Fixed or variable payments. Eg: LIBOR plus a margin on a sum equivalent to a loan on the value of the underlying portfolio of the issued ODI Distributions including dividends and capital gains Portfolio of listed securities on any recognized stock exchange in India This Space is Intentionally Left Blank 41

58 Provided upon request only B.Position of Tax on P-Notes Under sections 4 and 5 of the Tax Act, non-residents may be taxed only on income that accrues in India or which arises from sources in India. The source rules for specific types of income are contained in section 9, which specifies certain circumstances where such income is deemed to accrue or arise in India. Capital gains from the transfer or sale of shares or other securities of an Indian company held as capital assets would ordinarily be subject to tax in India (unless specifically exempted). Under section 9(1)(i) of the Tax Act, income earned by a non-resident from the transfer of a capital asset situated in India would be deemed to have been accrued in India (i.e. be sourced in India). Therefore, a non-resident may be liable to tax in India if it earns income from the transfer of a capital asset situated in India. In Vodafone International Holdings B.V. v. Union of India, 59 the Indian Supreme Court stated that the Indian tax authorities are to only look at a particular document or transaction when determining the taxability thereof, thus, indicating a form-over-substance approach with respect to taxation. Thus, in light of the above-mentioned determination, an indirect transfer of capital assets situated in India, between two non-residents, executed outside India was held to be not taxable under the Tax Act. In response to the decision of the Supreme Court, a retroactive clarification was inserted in the Tax Act by the Finance Act, 2012, to state that such foreign shares or interest may be treated as a capital asset situated in India if it derives, directly or indirectly, its value substantially from assets located in India. The newly introduced Explanation 5 to section 9(1)(i) expands the source rule to cover shares or interest in a foreign company, the value of which is substantially derived from assets situated in India. However, while the foreign shares / interest may be deemed to be situated in India, the charge of capital gains tax may not extend to that portion of its value relating to assets located outside India. Assets located outside India do not have any nexus with the territory of India to justify taxation under the Tax Act. It is, therefore, necessary to read down the amended section 9(1)(i) based on the nexus principle. In case of an ODI holder, while the value of the ODI can be linked to the value of an asset located in India (equity, index or other forms of underlying securities from which the swap derives its value), it is a contractual arrangement that does not typically obligate the ODI issuer to acquire or dispose the referenced security. The Protocol amending the India-Mauritius DTAA may have an adverse effect on ODI issuers that are based out of Mauritius. While most of the issuers have arrangements to pass off the tax cost to their subscribers, the arrangement may have complications due to a timing mismatch as the issuer could be subject to tax on a FIFO basis (as opposed to a one-to-one co-relation). III. Onshore Hedge Funds As has been previously discussed, SEBI introduced different categories of AIFs to cater to different investment strategies. Category III AIFs is a fund which employs diverse or complex trading strategies and may involve leverage including through investments in listed or unlisted derivatives. While the general characteristics of Category III AIFs have been discussed previously, it is important to stress on certain key aspects. The AIF Regulations provide that Category III AIFs may engage in leverage or borrow subject to consent from the investors in the fund and subject to a maximum limit specified by SEBI. On July 29, 2013, SEBI issued a circular 60 which lays down certain important rules relating to redemption restrictions and leverage. 59. Vodafone International Holdings B.V. v. Union of India & Anr. [S.L.P. (C) No of 2010, dated 20 January 2012]. 60. SEBI Circular CIR/IMD/DF/10/

59 Fund Structuring & Operations Legal & Tax Issues A. Suspension of Redemptions A Category III AIF cannot suspend redemptions unless the possibility of suspension of redemptions has been disclosed in the placement memorandum and such suspension can be justified as being under exceptional circumstances and in the best interest of investors. Further, in the event of a suspension of redemption, a fund manager cannot accept new subscriptions and will have to meet the following additional obligations: a. Document reasons for suspension of redemption and communicate the same to SEBI; b. Build operational capability to suspend redemptions in an orderly and efficient manner; c. Keep investors informed about actions taken throughout the period of suspension; d. Regularly review the suspension and take necessary steps to resume normal operations; and e. Communicate the decision to resume normal operations to SEBI. B. Leverage Guidelines SEBI limits the leverage that can be employed by any scheme of a fund to two times (2x) the net asset value ( NAV ) of the fund. The leverage of a given scheme is calculated as the ratio of total exposure of the scheme to the prevailing NAV of the fund. While calculating leverage, the following points should be kept in mind: c. Further, temporary borrowing arrangements which relate to and are fully covered by capital commitments from investors are excluded from the calculation of leverage; d. Offsetting of positions shall be allowed for calculation of leverage in accordance with the SEBI norms for hedging and portfolio rebalancing; and e. NAV shall be the sum of value of all securities adjusted for mark to market gains / losses including cash and cash equivalents but excluding any borrowings made by the fund. The AIF Regulations require all Category III AIFs to appoint a custodian. In the event of a breach of the leverage limit at any time, fund managers will have to disclose such breach to the custodian who in turn is expected to report the breach to SEBI before 10 AM, IST (India Standard Time) on the next working day. The fund manager is also required to communicate the breach of the leverage limit to investors of the fund before 10 AM, IST on the next working day and square off the excess exposure to rebalance leverage within the prescribed limit by the end of the next working day. When exposure has been squared off and leverage has been brought back within the prescribed limit, the fund manager must confirm the same to the investors whereas the custodian must communicate a similar confirmation to SEBI. a. Total exposure will be calculated as the sum of the market value of the long and short positions of all securities / contracts held by the fund; b. Idle cash and cash equivalents are excluded while calculating exposure; 43

60 Provided upon request only 8. Fund Governance A pooled investment vehicle typically seeks to adopt a robust governance structure. The genesis of this obligation (other than as may be required under applicable laws) is in the generally accepted fiduciary responsibilities of managers with respect to the investor s money. In a fund context, the decision making framework typically follows the following structure I. Investment Manager The investment manager is concerned with all activities of a fund including its investment and divestment related decisions. These are typically subject to overall supervision of the board of directors of the fund (if set up in the format of a company ). II. Investment Committee The Investment Committee ( IC ) scrutinizes all potential transactions (acquisition as well as exit). The IC s role includes maintaining pricing discipline, ensuring that all transactions adhere to the fund s strategy and assessing the risk -return profile of the deals. The functions of the IC typically include review of (1) transactions that are proposed by the investment manager, (2) performance, risk profile and management of the investment portfolio and (3) to provide appropriate recommendations to the investment manager. III. Advisory Board Typically, the Advisory Board s role is to provide informed guidance to the investment manager / IC of the fund based on the information / reports shared by the investment manager with the Advisory Board. The Advisory Board typically provide recommendations to the investment manager / IC in relation to (1) managing conflicts of interest situations; (2) approval of investments made beyond the threshold levels as may have been defined in the fund documents; (3) investment manager s overall approach to investment risk management and; (4) corporate governance and compliance related aspects. IV. Aspects and Fiduciaries to be considered by Fund Directors The emerging jurisprudence suggests that the threshold of fiduciaries that is required to be met by the directors is shifting from sustained or systematic failure to exercise oversight to making reasonable and proportionate efforts commensurate with the situations. A failure to perform their supervisory role could raise several issues concerning liabilities of independent directors for resultant business losses as would be seen in the case of Weavering Macro Fixed Income Fund (summarized below). As a matter of brief background, Weavering Macro Fixed Income Fund ( Fund ) was a Cayman Islands based hedge fund. The Fund appointed an investment manager to manage the affairs of the Fund subject to the overall supervision of the Directors. The Fund went into liquidation at which point in time, action for damages was initiated by the official liquidators against the former independent directors. The Grand Court of Cayman Islands found evidence that while board meetings were held in a timely manner, the meetings largely recorded information that was also present in the communication to fund investors and that the directors were performing administrative functions in so far as they merely signed the documents that were placed before them. 44

61 Fund Structuring & Operations Legal & Tax Issues Based on such factual matrix, the Grand Court held against the directors for wilful neglect in carrying out their duties. It was also observed that based on their inactions, the defendant directors did nothing and carried on doing nothing. The measure of loss was determined on the difference between the Fund s actual financial position with that of the hypothetical financial position had the relevant duties been performed by the directors. The Grand Court ruled against each of the directors in the amount of $111 million. It was also observed, that the comfort from indemnity clauses are for reasonably diligent independent directors to protect those who make an attempt to perform their duties but fail, not those who made no serious attempt to perform their duties at all. The Grand Court observed that the directors are bound by a number of common law and fiduciary duties including those to (1) act in good faith in the best interests of the fund and (2) to exercise independent judgment, reasonable care, skill and diligence when acting in the fund s interests. However, the Cayman Islands Court of Appeal ( CICA ) set-aside the order of Cayman Islands Grand Court in the case of Weavering Macro Fixed Income Fund Limited (In Liquidation) vs. Stefan Peterson and Hans Ekstrom, through its judgment dated February 12, The CICA, while affirming the original findings of breach of duty by the directors held that there was no element of wilful negligence or default on their part; therefore, the indemnity provisions in the Fund documents relieved the directors from liability arising out of breach of their duties. The CICA held that the evidence available to the Grand Court was insufficient to support the finding that the directors conduct amounted to wilful neglect or default. The CICA accordingly set aside the earlier judgments against each of the directors for $111 million. Further, in India, the recent case of RBI & Ors v Jayantilal N. Mistry & Ors 61 the Supreme Court of India considered the meaning of the term fiduciary, and held that it referred to a person having a duty to act for the benefit of another (a duty of loyalty ), showing good faith and candour ( duty of care ), where such other person reposes trust and special confidence in the person owing or discharging the duty. The court took the view that the term fiduciary relationship is used to describe a situation or transaction wherein one person (the beneficiary) places complete confidence in another person (the fiduciary) in regard to his affairs, business or transaction(s). The term also referred to a person who held a thing in trust for another (the beneficiary). The fiduciary is expected to act in confidence and for the benefit and advantage of the beneficiary, and to employ good faith and fairness in dealing with the beneficiary or with things belonging to the beneficiary. In the aforesaid case, the court held that RBI has no legal duty to maximixe the benefit of any public sector bank, and thus there is no relationship of trust between them. 62 In a relevant case, HMRC v Holland 63 it was observed that the fact that a person is consulted about directorial decisions, or asked for approval, does not in general make him a director because he is not making the decision. From a regulatory point of view, Regulation 21 of the AIF Regulations states that, in addition to the trustee (the discharge of whose trusteeship services constitutes a fiduciary relationship with the investors), it is the sponsor and the investment manager of the AIF that are to act in a fiduciary capacity toward the investors. In light of the above, it becomes important to ensure that the Advisory Board of the Fund is not given any roles or responsibilities with respect to the Fund which would subject the members to fiduciary duties. 61. AIR2016SC1 62. ibid 63. [2010] 1 WLR

62 Provided upon request only We summarize below the duties of directors (of fund managers, in case the fund is not self-managed) based on the above judgments that should guide a director during the following phases in the life of a fund: A. At the Fund Formation Stage Directors must satisfy themselves that the offering documents comply with applicable laws, that all conflict of interest situations are addressed upfront, that the structure of the fund is not only legally compliant but also ethically permissible, that the terms of the service providers contracts are reasonable and consistent with industry standards, and that the overall structure of the fund will ensure a proper division of responsibility among service providers. Directors must act in the best interests of the fund which, in this context, means its future investors. In this respect, we believe verification notes can be generated. The notes would record the steps which have been taken to verify the facts, the statements of opinion and expectation, contained in the fund s offering document(s). The notes also serve the further purpose of protecting the directors who may incur civil and criminal liability for any untrue and misleading statements therein or material or misleading omissions therefrom. Alternatively, a closing opinion may also be relied upon. B. During the Fund s Tenure i. Appointment of Service Providers Directors should consider carefully which service providers are selected for appointment. They should understand the nature of the services to be provided by the service providers to the fund. ii. Agenda The formalities of conducting proper board meetings should be observed. An agenda for such meetings should list the matters up for discussion, materials to be inspected, and inputs from the manager, the service providers and directors themselves. It should be circulated well in advance. iii. Actions Outside Board Meetings The directors should review reports and information that they received from the administrator and auditors from time to time to independently assess the functioning of the fund and whether it is in keeping with the fund s investment strategy and compliant with the applicable laws. iv. Decision Making Process Directors should exhibit that there was an application of mind when considering different proposals before it. The decision making process will also play a pivotal role in determining the substance of the Fund from an Indian tax perspective as India moves away from its principle of form over substance to substance over form post April 01, For example, in case of investor side letters that may restrict the fund s investments into a restricted asset class, etc., could raise issues. While execution of such side letters may not be harmful to the Fund, but an approval at short notice may be taken up to reflect on the manner in which the directors perform their duties. v. Minutes Board meetings should be followed by accurately recorded minutes. They should be able to demonstrate how the decision was arrived at and resolution thereon passed. The minutes should reflect that the directors were aware of the issues that were being discussed. Clearly, a boilerplate approach would not work. vi. Remuneration The remuneration for independent directors should be commensurate to the role and functions expected to be discharged by them. While a more-thanadequate remuneration does not establish anything, an inadequate recompense can be taken as a ground to question whether the concerned director intends to perform his / her duties to the Fund. 46

63 Fund Structuring & Operations Legal & Tax Issues vii. Conflict of interest If related party transactions or transactions that may raise conflict of interest cannot be avoided, a policy should be outlined where events and mechanisms to identify and resolve events which could lead to potential conflicts, should be recorded. Suitable measures that demonstrate governance and that the interest of the investors would be unimpaired, should be adopted. The rulings discussed confirm that a fund s board has duties cast on it and the business judgment rule may ensure that liability is not shielded in all cases. There are certain non-delegable functions for the directors to discharge on an on-going basis and none are more paramount than reviewing of the fund s performance, portfolio composition and ensuring that an effective compliance program is in place. These functions require action between board meetings and not only during board meetings. 47

64 Provided upon request only 9. International Tax Considerations I. Taxation of Indirect Transfers In India, residents are taxable on their worldwide income whereas non-residents are taxable on Indian source income i.e. income that accrues or arises, or is deemed to accrue or arise, or is received or is deemed to be received in India. As stated above, for a non-resident to be subject to tax in India, the Tax Act requires that the income should be received, accrued, arise or deemed to be received, accrued or arisen to him in India. 64 In this regard, section 9(1)(i) of the Tax Act provides the circumstances under which income of a non- resident may be deemed to accrue or arise in India: Section 9(1): The following income shall be deemed to accrue or arise in India: (i) all income accruing or arising, whether directly or indirectly, through or from any business connection in India, or through or from any property in India, or through or from any asset or source of income in India, or through the transfer of a capital asset situated in India. This source rule pertaining to a capital asset situate in India was examined by the Supreme Court of India in Vodafone International Holdings 65, which dealt with transfer of shares of a foreign company between two non-residents. It was held that a share is legally situated at the place of incorporation of the company. Therefore, while the shares of an Indian company would be considered situated in India, the shares of a company incorporated outside India would ordinarily be viewed as situated outside India. 64. Section5(2) of the Tax Act. 65. (2012) 341 ITR 1. asset being any share or interest in a company or entity regis- tered or incorporated outside India shall be deemed to be situat- ed in India, if the share or interest derives, directly or indirectly, its value from the assets located in India being more than 50% of the global assets of such company or entity. This position has undergone a change pursuant to the Finance Act, 2012, which amended section 9 of the Tax Act through the insertion of Explanation 5 cited below: For the removal of doubts, it is hereby clarified that an asset or a capital asset being any share or interest in a company or entity registered or incorporated outside India shall be deemed to be and shall always be deemed to have been situated in India, if the share or interest derives, directly or indirectly, its value substantially from the assets located in India. Therefore, under the current law, shares of a foreign incorporated company can be considered to be a situate in India if the company derives its value substantially from assets located in India. On the basis of the recommendations provided by the Shome Committee appointed by the then Prime Minister, the Finance Act, 2015 had made various amendments to these provisions which are summarized below: A.Threshold test on substantiality and valuation The Tax Act, pursuant to amendment by the Finance Act, 2015, provides that the share or interest of a foreign company or entity shall be deemed to derive its value substantially from the assets (whether tangible or intangible) located in India, if on the specified date, the value of Indian assets (i) exceeds the amount of INR 100 million; and (ii) represents at least 50% of the value of all the assets owned by the company or entity. The value of the assets shall be the Fair Market Value ( FMV ) of such asset, without eduction of liabilities, if any, in respect of the asset Explanation 6 to Section 9(1)(i) of the Tax Act. 48

65 Fund Structuring & Operations Legal & Tax Issues i. Date for determining valuation Typically, the end of the accounting period preceding the date of transfer shall be the specified date of valuation. However, in a situation when the book value of the assets on the date of transfer exceeds by at least 15%, the book value of the assets as on the last balance sheet date preceding the date of transfer, then the specified date shall be the date of transfer. This results in ambiguity especially in cases where intangibles are being transferred. ii. Taxation of gains The gains arising on transfer of a share or interest deriving, directly or indirectly, its value substantially from assets located in India will be taxed on a proportional basis based on the assets located in India vis-à-vis global assets. Exemptions: The Finance Act, 2015, provides for situations when this provision shall not be applicable. These are: a. Where the transferor of shares of or interest in a foreign entity, along with its related parties does not hold (i) the right of control or management; and (ii) the voting power or share capital or interest exceeding 5% of the total voting power or total share capital in the foreign company or entity directly holding the Indian assets (Holding Co). b. In case the transfer is of shares or interest in a foreign entity which does not hold the Indian assets directly, then the exemption shall be available to the transferor if it along with related parties does not hold (i) the right of management or control in relation to such company or the entity; and (ii) any rights in such company which would entitle it to either exercise control or management of the Holding Co. or entitle it to voting power exceeding 5% in the Holding Co. The 5% limit described above is a far cry from the 26% holding limit which was recommended by the Committee. Further, no exemption has been provided for listed companies, as was envisaged by the Committee. c. In case of business reorganization in the form of demergers and amalgamation, exemptions have been provided. The conditions for availing these exemptions are similar to the exemptions that are provided under the Tax Act to transactions of a similar nature. iii. Reporting Requirement The Tax Act, pursuant to amendment by the Finance Act, 2015, provides for a reporting obligation on the Indian entity through or in which the Indian assets are held by the foreign entity. The Indian entity has been obligated to furnish information relating to the offshore transaction which will have the effect of directly or indirectly modifying the ownership structure or control of the Indian entity. In case of any failure on the part of Indian entity to furnish such information, a penalty ranging from INR 500,000 to 2% of the value of the transaction can be levied. In this context, it should be pointed out that it may be difficult for the Indian entity to furnish information in case of an indirect change in ownership, especially in cases of listed companies. Further, there is no minimum threshold beyond which the reporting requirement kicks in. This means that even in a case where one share is transferred, the Indian entity will need to report such change. All in all, while these provisions provide some relief to investors, a number of recommendations as provided by the Committee have not been considered by the GoI. Some of these recommendations related to exemption to listed securities, P-Notes and availability of DTAA benefits. Further, there are no provisions for grandfathering of existing investment made in the past and questions arise as to the tax treatment on transactions undertaken between 2012 and Although in last year s budget, the Finance Minister had clarified that assessing officers will not issue retrospective notices in relation to these provisions. Yet another issue that has not been considered is the 49

66 Provided upon request only potential double taxation that can happen, especially in multi-layered structures. Further, no changes have been made to the wide definition of transfer which could potentially cover unintended activities like pledge / mortgage of property of the foreign company having assets located in India. A fundamental question that ought to have been addressed is whether such tax policy is in consonance with global tax policies and the Finance Minister should have actually taken the bold step of scrapping the provisions from the Tax Act in entirety. In the current form, we can expect further litigation on various issues relating to the indirect transfer provisions for the foreseeable future. The Finance Act, 2017 brought changes to clarify that the indirect transfer tax provisions shall not be applicable to an asset or capital asset that is held directly/ indirectly by way of investment in an FII, a Category I FPI or a Category II FPI. This resolves concerns for a class of offshore funds which are registered as a category I or category II FPIs as redemptions by investors at the level of the fund shall not be subject to the indirect transfer taxation. Further, in multi-tiered structures, if the entity investing into India is a Category I or Category II FPI, any upstreaming of proceeds by way of redemption / buyback will not be brought within the Indian tax net. The provisions also exclude, from applicability of the indirect transfer tax provisions, situations where any redemptions or re-organizations or sales result in capital gains by investors in Category I or Category II FPIs. The clarificatory explanations are applicable retrospectively from FY starting April 1, 2012, and therefore should help bring about certainty on past transactions that have been entered into by FII, Category I and Category II FPI entities. The amendment has left out a large chunk of the affected sector i.e. Category III FPIs, PE and VC investors investing in Indian securities. During the 2017 Budget speech, the Finance Minister indicated that further clarifications will be issued with respect to redemptions or buybacks of shares or interests in any foreign company (having underlying Indian investments) as a result of or arising out of the redemption or sale of Indian securities which are chargeable to Indian taxes would be exempt from the applicability of the indirect transfer tax provisions. While the text of the Finance Act did not stipulate this, a separate clarification may be issued as stated by the Finance Minister in the Budget speech. II. General Anti-Avoidance Rule (GAAR) Chapter X-A of the ITA provides for GAAR, which has come into effect from April 1, GAAR confers broad powers on the revenue authorities to deny tax benefits (including tax benefits applicable under the DTAA), if the tax benefits arise from arrangements that are impermissible avoidance arrangements The introduction of GAAR in the ITA is effective from financial year and brings a shift towards a substance based approach. GAAR targets arrangements whose main purpose is to obtain a tax benefit and arrangements which are not at arm s length, lack commercial substance, are abusive or are not bona fide. It grants tax authorities powers to disregard any structure, reallocate / re-characterize income, deny DTAA relief etc. Further, the ITA provides that GAAR is not applicable in respect of any income arising from transfer of investments which are made before April 1, Section 90(2A) of the ITA contains a specific DTAA override in respect of GAAR and states that the GAAR shall apply to an assessee with respect to DTAAs, even if such provisions are not beneficial to the assessee. On January 27, 2017, the CBDT issued Circular No. 7 of 2017 containing clarifications on the implementation of GAAR. Herein, the CBDT has clarified that GAAR will not interplay with the right of a taxpayer to select or choose the method of implementing a transaction. Further, the CBDT has 50

67 Fund Structuring & Operations Legal & Tax Issues clarified that GAAR shall not be invoked merely on the ground that an entity is located in a tax efficient jurisdiction. Specifically in response to a query raised with regard to issuance of P-notes referencing Indian securities, the CBDT has clarified that if the jurisdiction of an FPI is finalized based on non-tax commercial considerations and the main purpose of the arrangement is not to obtain a tax benefit, then GAAR will not apply. The Supreme Court ruling in McDowell & Co. Ltd. v. CTO 67 stated that under the Indian tax laws, even while predominantly respecting legal form, the substance of a transaction could not be ignored where it involved sham or colorable devices to reduce an entity s tax liabilities. Therefore, as per judicial anti-avoidance principles, the Indian tax authorities have the ability to ignore the form of the transaction only in very limited circumstances where it is a sham transaction or a colourable device. The GAAR provisions extend the power of the Indian tax authorities to disregard transactions even when such transactions / structures are not a sham in case where they amount to an impermissible avoidance arrangement. An impermissible avoidance arrangement has been defined as an arrangement entered into with the main purpose of obtaining a tax benefit. These provisions empower the tax authorities to declare any arrangement as an impermissible avoidance arrangement if the arrangement has been entered into with the principal purpose of obtaining a tax benefit and involves one of the following elements: A. Non-arm s Length Dealings It refers to arrangements that create rights or obligations not normally created between independent parties transacting on an arm s length basis. B. Misuse or Abuse of the Provisions of the Act It results directly or indirectly, in the misuse or abuse of the Tax Act. C. Lack of Commercial Substance Arrangements that lack commercial substance or are deemed to lack commercial substance- this would include round trip financing involving transfer of funds between parties without any substantial commercial purpose, self-cancelling transactions, arrangements which conceal, and the use of an accommodating party, the only purpose of which is to obtain a tax benefit. Arrangements are also deemed to lack commercial substance if the location of assets, place of transaction or the residence of parties does not have any substantial commercial purpose. D. Non-Bona Fide Purpose Arrangements that are carried out by means or in a manner which is not ordinarily employed for a bona fide purpose. In the event that a transaction / arrangement is determined as being an impermissible avoidance arrangement, the Indian tax authorities would have the power to disregard entities in a structure, reallocate income and expenditure between parties to the arrangement, alter the tax residence of such entities and the legal situs of assets involved, treat debt as equity, vice versa, and the like. The tax authorities may deny tax benefits even if conferred under a DTAA, in case of an impermissible avoidance arrangement. Investors have been worried about the scope of the GAAR provisions and concerns have been raised on how they would be implemented. A re-look at the scope of the provisions will definitely be welcomed by the investment community and it is hoped that when revised provisions are introduced, they will be in line with global practices ITR

68 Provided upon request only III. Business Connection / Permanent Establishment Exposure Offshore funds investing in India have a potential tax exposure on account of having constituted a permanent establishment ( PE ) in India. In case of a PE determination, the profits of a non-resident entity are taxable in India only to the extent that the profits of such enterprise are attributable to the activities carried out through its PE in India. What constitutes permanent establishment? Management teams for India focused offshore funds are typically based outside India as an onshore fund manager enhances the risk of the fund being perceived as having a PE in India. Although DTAAs provide for the concept of a PE in Article 5 (as derived from the Organisation for Economic Co-operation and Development ( OECD ) and United Nations ( UN ) Model Convention), the expression has not been exhaustively defined anywhere. The Andhra Pradesh High Court, in CIT v. Visakhapatnam Port Trust (144 ITR 146), held that: The words permanent establishment postulate the existence of a substantial element of an enduring or permanent nature of a foreign enterprise in another country which can be attributed to a fixed place of business in that country. It should be of such a nature that it would amount to a virtual projection of the foreign enterprise of one country into the soil of another country. The presence of the manager in India could be construed as a place of management of the offshore fund and thus the manager could be held to constitute a permanent establishment. Consequently, the profits of the offshore fund to the extent attributable to the permanent establishment, may be subject to additional tax in India. What tantamounts to business connection in the context of an offshore fund? Business connection is the Indian domestic tax law equivalent of the concept of PE under a DTAA scenario. The term business connection, however, is much wider. The term has been provided as an inclusive definition per Explanation 2 to Section 9(1)(i) of the Tax Act, whereby a business connection shall be constituted if any business activity is carried out through a person who (acting on behalf of the non-resident) has and habitually exercises in India the authority to conclude contracts on behalf of the non-resident. Thus, the legislative intent suggests that (in absence of a DTAA between India and the jurisdiction in which the offshore fund has been set up) under the business connection rule, an India based fund manager may be identified as a business connection for the concerned offshore fund. It is important to note that the phrase business connection is incapable of exhaustive enumeration, given that the Tax Act provides an explanatory meaning of the term which has been defined inclusively. A close financial association between a resident and a non-resident entity may result in a business connection for the latter in India. The terms of mandate and the nature of activities of a fund manager are such that they can be construed as being connected with the business activity of the offshore fund in India. Accordingly, offshore funds did not typically retain fund managers based in India when a very real possibility existed that the fund manager could be perceived as a PE or a business connection for the fund in India. Instead, many fund managers that manage India focused offshore funds, tend to be based outside India and only have an advisory relationship in India that provide recommendatory services. However, the Finance Act, 2015 introduced amendments to encourage fund management activities in India by providing that having an eligible manager in India should not create a tax presence (business connection) for the fund in India or result in the fund being considered a resident in India under the domestic place of effective management rule and introducing section 9A to the Tax Act. 52

69 Fund Structuring & Operations Legal & Tax Issues While Section 9A may be well intentioned, it employs a number of rigid criteria that would be impossible for PE funds and difficult for FPIs to satisfy. Under section 9A of the Tax Act, if the Fund is falling within the criteria given in Section 9A (3), then the said Fund will not be taken as resident in India merely because the eligible fund manager, undertaking fund management activities, is situated in India. The conditions given under Section 9A are as follows:- (i) the fund must not be a person resident in India; (ii) the fund must be a resident of a country with which India has entered into an agreement under Section 90(1) or 90A(1) of the Tax Act or is established or incorporated or registered in a country or a specified territory notified by the GoI in this behalf; (iii) investment in the fund by persons resident in India should not exceed 5% of the corpus of the fund; (iv) the fund and its activities are subject to investment protection regulations in the country in which it is incorporated or resident; (v) the fund must have minimum twenty five members, who are not connected persons (vi) any member of the fund along with connected persons should not have any participation interest in the fund exceeding 10 % (vii) the aggregate participation interest of ten or less members along with their connected persons in the fund, should be less than 50% (viii) the fund should not invest more than 20%. of its corpus in any single entity (ix) the fund should not make any investment in its associate entity; (x) the monthly average of the corpus of the fund should not be less than INR 1 billion; however, this provision shall not be applicable in case of the year in which the fund is wound up. (xi) the fund should not carry on or control and manage, directly or indirectly, any business in India (xii) the fund should not engage in any activity which will constitute business connection in India; (xiii) the remuneration paid by the fund to the fund manager should be not less than the arm s length price. Added to this are certain relaxations provided to the fund set up by the government or the Central Bank of a foreign state or a sovereign Fund, or any other Fund as notified by the GoI These funds do not have to comply with the conditions given in clauses (v), (vi) and (vii) of the above given conditions. Despite the efforts of the government in the previous two financial years, onerous conditions such as the requirement to have a minimum of twenty-five investors and the requirement to charge fee that is not less than the arm s length price continue to act as roadblocks in the progress of the provision, as explained in detail below. Furthermore, regard must also be had to the fact that Section 9A primarily caters to managers of openended funds. Private equity and venture capital funds are unlikely to consider using the provision as the minimum investor requirement, the requirement to not invest more than 20% of corpus in one entity and the restriction on controlling businesses in India make it impractical for such funds to consider using the safe harbour. This is in fact, a mismatch for the industry as India focused private equity and venture capital funds have a greater need to have management personnel based out of India. A. No ability to control and manage To qualify, the fund shall not carry on or control and manage, directly and indirectly, any business in India. It is unclear whether shareholders rights such as affirmative rights can be considered control and management. Further, this exemption will not be available to buy-out / growth funds, since such funds typically take a controlling stake and management rights in the portfolio companies; B. Broad basing requirement The fund is required to have a minimum of 25 members who are directly / indirectly unconnected persons. This seems similar to the broad-basing criteria applied to Category II FPIs and isn t quite appropriate for private equity / venture capital funds which may often have fewer investors. Further, there is no clarity on whether the test will be applied on a look through basis (which could impact master- feeder structures); 53

70 Provided upon request only C. Restriction on investor commitment It is required that any member of the fund, along with connected persons should not have a participation interest exceeding 10%. It has also been stated that the aggregate participation of ten or less people should be less than 50%. This would restrict the ability of the fund sponsor / anchor investor to have a greater participation. It would also have an impact on master feeder structures or structures where separate subfunds are set up for ring fencing purposes; D. Fund manager cannot be an employee The exemption does not extend to fund managers who are employees or connected persons of the fund. Furthermore, it is not customary in industry to engage managers on a consultancy / independent basis, for reasons of risk and confidentiality, particularly in a private equity / venture capital fund context. Therefore, this requirement is likely to be very rarely met. The proposed amendments do not leave funds worse off however, they are unlikely to provide benefit to private equity / venture capital funds or FPIs. Firstly, a fund manager exemption is more relevant in a private equity / venture capital context, where on ground management is more of a necessity. For the reasons discussed above, private equity / venture capital funds are unlikely to be able to take advantage of section 9A. If the intent was to provide PE exclusion benefits to FPIs investing in listed securities, it would have been more appropriate to clarify the risk on account of colocation servers in India on which automated trading platforms are installed. Secondly, FPI income is characterized as capital gains, and hence, the permanent establishment exclusion may only be relevant to a limited extent. 54

71 Fund Structuring & Operations Legal & Tax Issues Annexure I Sector Focused Funds I. Social Venture Funds A. Introduction Although existent in practice, it is only under the AIF Regulations that social venture funds were formally recognized. Under the AIF Regulations, a social venture fund is defined as, an alternative investment fund which invests primarily in securities or units of social ventures and which satisfies social performance norms laid down by the fund and whose investors may agree to receive restricted or muted returns. Typically, social venture funds tend to be impact funds which predominantly invest in sustainable and innovative business models. The investment manager of such fund is expected to recognise that there is a need to forecast social value, track and evaluate performance over time and assess investments made by such funds. B. Characteristics of Social Venture Funds Social venture funds tend to be different from venture capital funds or private equity funds not just in the investments that they make, but also in the nature of commitments that they receive from their limited partners / investors. The following is a list of some of the characteristics that a social venture fund may expect to have: Investors making grants (without expectation of returns) instead of investments; Fund itself providing grants and capital support considering social impact of such participation as opposed to returns on investment alone; Fund targeting par returns or below par returns instead of a fixed double digit IRR; Management team of the fund participating in mentoring, incubating and growing their portfolio companies, resulting in limited token investments (similar to a seed funding amount), with additional capital infused as and when the portfolio grows; Moderate to long term fund lives in order to adequately support portfolio companies. Social venture funds also tend to be aligned towards environmental, infrastructure and socially relevant sectors which would have an immediate impact in the geographies where the portfolio companies operate. C. Tools to Measure Social Impact Managers of social impact funds rely on specific systems to quantify the social value of investments. Some of these include: Best Alternative Charitable Option ( BACO ), developed by the Acumen Fund. Impact Reporting & Investment Standards ( IRIS ), developed by Global Impact Investing Network ( GIIN ). Global Impact Investing Rating System ( GIIRS ). D. Laws Relating to Social Venture Funds Investing into India Offshore social venture funds tend to pool capital (and grants) outside India and make investments in India like a typical venture capital fund. Such 55

72 Provided upon request only offshore funds may not directly make grants to otherwise eligible Indian opportunities, since that may require regulatory approval. Onshore social venture funds are required to be registered as a Category I AIF under the specific sub- category of social venture funds. In addition to the requirement to fulfill the conditions set out in the definition (set out above), social venture funds under the AIF Regulations are subject to the following restrictions and conditions: Requirement to have at least 75% of their investible funds invested in unlisted securities or partnership interest of social ventures 68 ; Allowed to receive grants (in so far as they conform to the above investment restriction) and provide grants. Relevant disclosure in the placement memorandum of the fund will have to be provided if the social venture fund is considering providing grants as well; and Allowed to receive muted returns. II. Media Funds A. Media Funds An Introduction A media fund seeks to provide select sophisticated investors with an opportunity to participate in the financing of a portfolio of content, e.g., motion pictures and televisions serials. In current times, when demand for high quality films and media products has increased, such 68. Regulation 2(1)(u) of the AIF Regulations states social venture means a trust, society or company or venture capital undertaking or limited liability partnership formed with the purpose of promoting social welfare or solving social problems or providing social benefits and includes - i. public charitable trusts registered with Charity Commissioner; pooling platforms play the role of providing organized financing to various independent projects or work alongside studios and production houses. A unique feature is the multiple roles and level of involvement that the fund manager can undertake for the fund and its various projects. B. Media Funding Models Most film funds take a slate financing approach wherein the investment is made in a portfolio of films / media projects, as opposed to a specific project. However, as a variation, investors can even be introduced at the project specific level i.e. for a single production only. In terms of risk mitigation, the slate financing model works better than a specific project model owing to risk-diversification achieved for the investor. Apart from typical equity investments, film funds may additionally seek debt financing pursuant to credit facilities subject to compliance with local laws. E.g., in the Indian context, debt financing by offshore funds may not work. C. Risks and Mitigating Factors Film fund investors should take note of media industry specific risks such as - risk of abandonment of the project (execution risks), failure to obtain distributors for a particular project, increased dependence on key artists, increasing marketing costs, oversupply of similar products in the market, piracy, etc. To mitigate such risks, diversification of the projects could be maintained. Additionally, a strong and reliable green lighting mechanism could also be put in place whereby the key management of the fund decides the projects that should be green lit based on factors such as budgeted costs, available distributorship arrangements, sales estimates and so on. ii. societies registered for charitable purposes or for promotion of science, literature, or fine arts; iii. company registered under Section 25 of the Companies Act, 1956; iv. micro finance institutions. 56

73 Fund Structuring & Operations Legal & Tax Issues D. Life cycle of a Film Fund The life of a film fund in term of economic performance is generally in the range of 8 to 10 years depending upon the sources of revenue. Typically, sources of revenue of a film are a. Domestic and international theatrical release of the film; b. Domestic and international television markets; and c. Merchandizing of film related products, sound track releases, home video releases, release of the film on mobile platforms, and other such online platforms. Generally, a major portion of income from a film project is expected to be earned at the time of theatrical release of the film, or prior to release (through pre-sales). Consequently, the timing of revenue is generally fixed or more easily determinable in case of film investments, when compared to other asset classes. The box office proceeds of a film typically tend to be the highest source of revenue and also a key indicator of expected revenue from other streams. Thus, keeping the timing of revenue flows in mind, film funds are often structured as close ended funds having a limited fund life of 7 to 9 years. The term may vary depending on the number of projects intended to be green lit or the slate of motion pictures or other media projects intended to be produced. Typically, after the end of the life of the fund, all rights connected with the movie (including derivative rights) are sold or alternatively transferred to the service company or the fund manager on an arm s length basis. Derivative rights including rights in and to prequels, sequels, remakes, live stage productions, television programs, etc may also be retained by the investment manager (also possibly playing the role of the producer). Such transfer or assignment of residual rights is of course subject to the nature of and the extent of the right possessed by the fund or the concerned project specific SPV. E. Sources of income of a film fund and tax treatment i. Distributorship Arrangements The fund or the project specific SPV, as the case may be, may license each project to major distributors across territories in accordance with distribution agreements. Pursuant to such distribution agreements, the fund could expect to receive net receipts earned from the distributions less a distribution fee payable to the distributor (which typically consists of distribution costs and a percentage of net receipts). Income of this nature should generally be regarded as royalty income. If the distributor is in a different jurisdiction, there is generally a withholding tax at the distributor level. The rate of tax depends on the DTAA between the countries where the distributor is located, and where the fund / its project specific SPV is located. ii. Lock Stock and Barrel Sale The project exploitation rights may be sold outright on a profit margin for a fixed period or in perpetuity (complete ownership). This amounts to the project specific SPV selling all its interest in the IP of the movie for a lump sum consideration. iii. Use of an Appropriate Intermediary Jurisdiction Fund vehicles have historically been located in investor friendly and tax neutral jurisdictions. The unique nature of film funds adds another dimension i.e. intellectual property ( IP ) while choosing an appropriate jurisdiction. Generally, an IP friendly jurisdiction is chosen for housing the intellectual property of the fund or specific project. Further, since considerable amount of income earned by the fund may be in the form of royalties, a jurisdiction that has a favourable royalty clause in its DTAA with the country of the distributor may be used. This assumes greater importance because the royalty withholding tax rate under the Tax Act is 25%. 57

74 Provided upon request only Due to its protective regime towards IP, low tax rates and extensive treaty network, Ireland has been a preferred jurisdiction for holding media related IP. F. Role of Services Company In a film fund structure, certain acquisition, development, production and related services may be performed by a separate entity ( Services Company ). The Services Company may have a contractual relationship with the fund or its project specific subsidiaries, during the term of the fund. Depending upon circumstances of each project, the fund may engage the Services Company directly or through a special purpose subsidiary to provide production services. In respect of these services, the Services Company receives a fee which can be included within the fund s operational costs. The role of the Services Company / fund may also be fulfilled by the fund manager. The Services Company / manager may also hold the intellectual property associated with each project that may be licensed to or acquired by the fund or its project specific subsidiaries. G. Role of the Fund Manager The fund manager may take up the responsibilities of the Service Company as indicated above. Once a specific project is selected and green-lit by the manager, all underlying rights necessary to produce and / or exploit the project may be transferred to the fund. In addition to such role, the manager would also be expected to play the role of the traditional manager of a pooled investment vehicle and expected to discharge its fiduciary obligations. To an extent, the same may require observing specific conflict of interest mechanisms considering the multiple functions that may be performed in the context of a film fund. 58

75 Fund Structuring & Operations Legal & Tax Issues Annexure II Summary of Tax Treatment for Mauritius and Singapore Based Entities Participating in Indian Opportunities The following table summarizes the (i) requirements for eligibility under the India-Mauritius DTAA and the India-Singapore DTAA, (ii) the substance requirements that companies in Mauritius and Singapore will have to demonstrate in order to claim benefits under the two DTAAs and (iii) the tax rates that should be applicable to companies under the relevant DTAAs read with the provisions of the domestic tax law Parameters General Eligibility to DTAA benefits Mauritius A person is considered a resident of Mauritius for relief under the DTAA, as long as it is liable to tax in Mauritius by reason of domicile, residence or place of management. The Indian tax authorities issued a Circular (789 of 2000) stating that a tax residency certificate (TRC) issued by the Mauritius tax authorities constitutes sufficient proof of residence in Mauritius and entitlement to DTAA relief. The landmark decision of the Indian Supreme Court in Union of India v. Azadi Bachao Andolan 69, upheld the validity of the aforesaid Circular 789. Following this case, a number of cases have confirmed DTAA benefits for Mauritius based investors including: Dynamic India Fund I 70 ; DDIT v. Saraswati Holdings Corporation 71 ; E*Trade; In Re: Castleton 72 and D.B.Zwirn Mauritius Trading. 73 Singapore The management and control of business of the pooling vehicle must be in Singapore. 74 Tax resident companies are eligible for DTAA benefits subject to (as a practical matter) being able to obtain a tax residency certificate from the Inland Revenue Authority of Singapore. 69. [2003] 263 ITR 707 (SC). 70. [2009] 111 TTJ [2010] 324 ITR 1 (AAR). 72. [2011] 333 ITR 32 (AAR). 73. AAR 1016/2010 dated 18th July, Section 2 of the SITA,

76 Provided upon request only Substance Require- ments The Financial Services Commission encour- ages a company holding a Global Business Licence 1 ( GBL-1 ) to have substance in Mauritius. Obtaining a GBL-1 s a pre-requisite to obtaining a TRC which in turn is necessary to enjoy benefits under the India-Mauritius DTAA. Among other things, the FSC considers whether the company: i. has at least 2 directors, resident in Mauritius, who are appropriately qualified and of sufficient calibre to exercise independence of mind and judgment; ii. maintains at all times its principal bank account in Mauritius; iii. keeps and maintains, at all times, its accounting records at its registered office in Mauritius; iv. prepares, or proposes to prepare its statutory financial statements and causes or proposes to have such financial statements to be audited in Mauritius; v. provide for meetings of directors to include at least two directors from Mauritius; and vi. is authorized / licensed as a collective investment scheme / closed-end fund / external pension scheme administered from Mauritius. Further, the company must have a local administrator, a local auditor and a local custodian to ensure that all meetings of the board of directors are held and chaired in Mauritius. The same shall ensure that the central administration of the company is in Mauritius. Further, the company must have a local administrator, a local auditor and a local custodian to ensure that all meetings of the board of directors are held and chaired in Mauritius. The same shall ensure that the central administration of the company is in Mauritius. The substance requirements from an India-Singapore DTAA perspective comes from within the treaty itself. The subsequently negotiated protocol to the India-Singapore DTAA requires that the Singapore entity must not be a shell or a conduit. A shell / conduit entity isone with negligible or nil business operations or with no real and continuous business activities carried out in Singapore. A Singapore resident is deemed not to be a shell or conduit if it is listed on a recognized stock exchange or if its annual operational expenditure is at least SGD 200,000 per year in the two years preceding the transfer of shares giving rise to capital gains. The term annual expenditure means expenditure incurred during a period of twelve months. The period of twenty four months shall be calculated by referring to two blocks of twelve months immediately preceding the date when the gains arise. Accordingly, if the affairs of the Singapore entity are arranged with the primary purpose of taking benefit of capital gains relief, the benefit may be denied even if the Singapore entity is considered to have commercial substance under the GAAR provisions or incurs annual operational expenditure of SGD 200,

77 Fund Structuring & Operations Legal & Tax Issues i. having office premises in Mauritius; ii. employing at least one person full-time at an administrative / technical level; iii. inserting a clause in its constitution providing that disputes arising from the constitution shall be resolved by way of arbitration in Mauritius; iv. holding assets (other than cash and shares / interests in another GBC-1 company) worth at least USD 100,000 in Mauritius; v. having its shares listed on a Mauritius stock exchange; and vi. incurring an annual expenditure that can reasonably be expected from a similar corporation controlled / managed from Mauritius. Tax Implications under the Relevant DTAA Dividends 0% (as per the provisions of the Tax Act. Dividend distributions made by an Indian company to its shareholders are subject to a levy of DDT at an effective rate of 20.36% of the dividends distribut- ed. The DDT payable by a company is in addition to the normal corporate tax). Capital Gains India will have the right to tax capital gains which arise from alienation of shares of a company resident in India acquired by a Mauritian tax resident on or after April 1, All investments made prior to April 1, 2017 and any exits/share transfers from such investments will not be subject to capital gains tax in India; provided that there is no permanent establishment in India. The taxation of capital gains arising to Mauritius residents from alienation of shares between April 1, 2017 and March 31, 2019 from investments made after April 1, 2017 will not exceed 50% of the domestic tax rate in India under the Tax Act subject to the limitation of benefits provision. The benefit of this reduced rate of tax will not be available if: 0% (pursuant to the provisions of the India-Sin- gapore DTAA, any capital gains earned by Singapore based entities on disposal of Indian securities should not be subject to tax in India. However, if such Singapore entities dispose any Indian securities prior to the completion of twenty four months from the date of incorporation of such entity, it is likely that the gains, if any, arising from such disposal, would be subject to tax in India if the annual expenditure is not met). 61

78 Provided upon request only Interest a. it is found that the affairs of the fund were arranged with the primary purpose to take advantage of the benefits of reduced rate of tax; or b. it is found that the fund is a shell/conduit company, i.e. a legal entity falling within the definition of resident with negligible or nil business operations or with no real and continuous business activities carried out in Mauritius. Further, the fund will be deemed to be a shell/conduit company if its expenditure on operations in Mauritius is less than Mauritian Rs. 1,500,000, in the immediately preceding period of 12 months from the date the gains arise; provided that, if the fund is listed on a recognized stock exchange in Mauritius or its expenditure on opera- tions in Mauritius is equal to or more than Mauritian Rs. 1,500,000, in the immedi- ately preceding period of 12 months from the date the gains arise. c. 7.5% on all interest income earned from an Indian company. Unless the DTAA with Singapore is renegotiated by India, benefits available in respect of capital gains under the India-Singapore DTAA shall fall away after April 01, Further, it is not clear whether the grandfathering of investments made before April 01, 2017 will be available to invest- ments made by Singapore residents. 15% (on a gross basis). Tax Implications if the Company is not Eligible to Claim Benefits under the Relevant DTAAs Capital Gains Short-term capital gains: Listed Securities (if the securities transaction tax is paid): 15% (plus applicable surcharge and cess). Unlisted Securities: 40% (plus applicable surcharge and cess). Long-term capital gains: Listed Securities (if the securities transaction tax is paid): 0% Unlisted Securities: 10% (without indexation) or 20% (with indexation benefits) (plus applicable surcharge and cess). 62

79 Fund Structuring & Operations Legal & Tax Issues About NDA Nishith Desai Associates (NDA) is a research based international law firm with offices in Mumbai, Bangalore, Palo Alto (Silicon Valley), Singapore, New Delhi, Munich and New York. We provide strategic legal, regulatory, and tax advice coupled with industry expertise in an integrated manner. As a firm of specialists, we work with select clients in select verticals on very complex and innovative transactions and disputes. Our forte includes innovation and strategic advice in futuristic areas of law such as those relating to Bitcoins (block chain), Internet of Things (IOT), Aviation, Artificial Intelligence, Privatization of Outer Space, Drones, Robotics, Virtual Reality, Med-Tech, Ed-Tech and Medical Devices and Nanotechnology. We specialize in Globalization, International Tax, Fund Formation, Corporate & M&A, Private Equity & Venture Capital, Intellectual Property, International Litigation and Dispute Resolution; Employment and HR, Intellectual Property, International Commercial Law and Private Client. Our industry expertise spans Automobile, Funds, Financial Services, IT and Telecom, Pharma and Healthcare, Media and Entertainment, Real Estate, Infrastructure and Education. Our key clientele comprise marquee Fortune 500 corporations. Our ability to innovate is endorsed through the numerous accolades gained over the years and we are also commended by industry peers for our inventive excellence that inspires others. NDA was ranked the Most Innovative Asia Pacific Law Firm in 2016 by the Financial Times - RSG Consulting Group in its prestigious FT Innovative Lawyers Asia-Pacific 2016 Awards. While this recognition marks NDA s ingress as an innovator among the globe s best law firms, NDA has previously won the award for the Most Innovative Indian Law Firm for two consecutive years in 2014 and As a research-centric firm, we strongly believe in constant knowledge expansion enabled through our dynamic Knowledge Management ( KM ) and Continuing Education ( CE ) programs. Our constant output through Webinars, Nishith.TV and Hotlines also serves as effective platforms for cross pollination of ideas and latest trends. Our trust-based, non-hierarchical, democratically managed organization that leverages research and knowledge to deliver premium services, high value, and a unique employer proposition has been developed into a global case study and published by John Wiley & Sons, USA in a feature titled Management by Trust in a Democratic Enterprise: A Law Firm Shapes Organizational Behavior to Create Competitive Advantage in the September 2009 issue of Global Business and Organizational Excellence (GBOE). A brief below chronicles our firm s global acclaim for its achievements and prowess through the years. IDEX Legal Awards: In 2015, NDA won the M&A Deal of the year, Best Dispute Management lawyer, Best Use of Innovation and Technology in a law firm and Best Dispute Management Firm< Nishith Desai was also recognized as the Managing Partner of the Year in Merger Market: has recognized NDA as the fastest growing M&A law firm in India for the year Legal 500 has ranked us in tier 1 for Investment Funds, Tax and Technology-Media-Telecom (TMT) practices (2011, 2012, 2013, 2014, 2017) 63

80 Provided upon request only International Financial Law Review (a Euromoney publication) in its IFLR1000 has placed Nishith Desai Associates in Tier 1 for Private Equity (2014, 2017). For three consecutive years, IFLR recognized us as the Indian Firm of the Year ( ) for our Technology - Media - Telecom (TMT) practice. Chambers and Partners has ranked us # 1 for Tax and Technology-Media-Telecom (2014, 2015, 2017); #1 in Employment Law (2015 & 2017); # 1 in Tax, TMT and Private Equity (2013, 2017); and # 1 for Tax, TMT and Real Estate FDI (2011). India Business Law Journal (IBLJ) has awarded Nishith Desai Associates for Private Equity, Structured Finance & Securitization, TMT, and Taxation in 2015 & 2014; for Employment Law in 2015 Legal Era recognized Nishith Desai Associates as the Best Tax Law Firm of the Year (2013). 64

81 Fund Structuring & Operations Legal & Tax Issues Please see the last page of this paper for the most recent research papers by our experts. Disclaimer This report is a copyright of Nishith Desai Associates. No reader should act on the basis of any statement contained herein without seeking professional advice. The authors and the firm expressly disclaim all and any liability to any person who has read this report, or otherwise, in respect of anything, and of consequences of anything done, or omitted to be done by any such person in reliance upon the contents of this report. Contact For any help or assistance please us on ndaconnect@nishithdesai.com or visit us at 65

82 Provided upon request only The following research papers and much more are available on our Knowledge Site: Fund Structuring and Operations Social Impact Investing in India The Curious Case of the Indian Gaming Laws June 2017 May 2017 October 2016 Corporate Social Responsibility & Social Business Models in India Incorporation of Company/LLP in India Outbound Acquisitions by India-Inc May 2017 April 2017 September 2014 Internet of Things Doing Business in India Private Equity and Private Debt Investments in India January 2017 June 2016 June 2015 NDA Insights TITLE TYPE DATE Blackstone s Boldest Bet in India M&A Lab January 2017 Foreign Investment Into Indian Special Situation Assets M&A Lab November 2016 Recent Learnings from Deal Making in India M&A Lab June 2016 ING Vysya - Kotak Bank : Rising M&As in Banking Sector M&A Lab January 2016 Cairn Vedanta : Fair or Socializing Vedanta s Debt? M&A Lab January 2016 Reliance Pipavav : Anil Ambani scoops Pipavav Defence M&A Lab January 2016 Sun Pharma Ranbaxy: A Panacea for Ranbaxy s ills? M&A Lab January 2015 Reliance Network18: Reliance tunes into Network18! M&A Lab January 2015 Thomas Cook Sterling Holiday: Let s Holiday Together! M&A Lab January 2015 Jet Etihad Jet Gets a Co-Pilot M&A Lab May 2014 Apollo s Bumpy Ride in Pursuit of Cooper M&A Lab May 2014 Diageo-USL- King of Good Times; Hands over Crown Jewel to Diageo M&A Lab May 2014 Copyright Amendment Bill 2012 receives Indian Parliament s assent IP Lab September 2013 Public M&A s in India: Takeover Code Dissected M&A Lab August 2013 File Foreign Application Prosecution History With Indian Patent Office IP Lab April 2013 Warburg - Future Capital - Deal Dissected M&A Lab January 2013 Real Financing - Onshore and Offshore Debt Funding Realty in India Realty Check May 2012 Pharma Patent Case Study IP Lab March 2012 Patni plays to igate s tunes M&A Lab January